Governments Step In

Before the Great Depression, policy makers often adopted a laissez-faire attitude toward banking crises, allowing banks to fail in the belief that market forces should be allowed to work. Since the catastrophe of the 1930s, though, almost all policy makers have believed that it’s necessary to take steps to contain the damage from bank failures. In general, central banks and governments take three main kinds of action in an effort to limit the fallout from banking crises:

  1. They act as the lender of last resort.
  2. They offer guarantees to depositors and others with claims on banks.
  3. In an extreme crisis, a central bank will step in and provide financing to private credit markets.

A lender of last resort is an institution, usually a country’s central bank, that provides funds to financial institutions when they are unable to borrow from the private credit markets.

1. Lender of Last Resort A lender of last resort is an institution, usually a country’s central bank, that provides funds to financial institutions when they are unable to borrow from the private credit markets. In particular, the central bank can provide cash to a bank that is facing a run by depositors but is fundamentally solvent, making it unnecessary for the bank to engage in fire sales of its assets to raise cash. This acts as a lifeline, working to prevent a loss of confidence in the bank’s solvency from turning into a self-fulfilling prophecy.

Did the Federal Reserve act as a lender of last resort in the 2008 financial crisis? Very much so. Figure 18-4 shows borrowing by banks from the Fed between 2005 and 2010: commercial banks borrowed negligible amounts from the central bank before the crisis, but their borrowing rose to $700 billion in the months following Lehman’s failure. To get a sense of how large this borrowing was, note that total bank reserves before the crisis were less than $50 billion—so these loans were 14 times the banks’ initial reserves.

Total Borrowings of Depository Institutions from the Federal Reserve Although commercial banks borrowed negligible amounts from the Fed before the crisis hit in 2008, in the months after Lehman’s collapse their borrowing surged to $700 billion—an amount 14 times total bank reserves before the crisis.
Source: Federal Reserve Bank of St. Louis.

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2. Government Guarantees" There are limits, though, to how much a lender of last resort can accomplish: it can’t restore confidence in a bank if there is good reason to believe the bank is fundamentally insolvent. If the public believes that the bank’s assets aren’t worth enough to cover its debts even if it doesn’t have to sell these assets on short notice, a lender of last resort isn’t going to help much. And in major banking crises there are often good reasons to believe that many banks are truly bankrupt.

In such cases, governments often step in to guarantee banks’ liabilities. In 2007, a bank run hit the British bank, Northern Rock, ceasing only when the British government stepped in and guaranteed all deposits at the bank, regardless of size. Ireland’s government eventually stepped in to guarantee repayment of not just deposits at all of the nation’s banks, but all bank debts. Sweden did the same thing after its 1991 banking crisis.

When governments take on banks’ risk, they often demand a quid pro quo—namely, they often take ownership of the banks they are rescuing. Northern Rock was nationalized in 2008. Sweden nationalized a significant part of its banking system in 1992. In the United States, the Federal Deposit Insurance Corporation routinely seizes banks that are no longer solvent; it seized 140 banks in 2009. Ireland, however, chose not to seize any of the banks whose debts were guaranteed by taxpayers.

These government takeovers are almost always temporary. In general, modern governments want to save banks, not run them. So they “reprivatize” nationalized banks, selling them to private buyers, as soon as they believe they can.

3. Provider of Direct Financing As we learned in Chapter 16, during the depths of the 2008 financial crisis the Federal Reserve expanded its operations beyond the usual measures of open-market operations and lending to depository banks. It also began lending to shadow banks and buying commercial paper—short-term bonds issued by private companies—as well as buying the debt of Fannie Mae and Freddie Mac, the government-sponsored home mortgage agencies. In this way, the Fed provided credit to keep the economy afloat when private credit markets had dried up.

Banks and the Great Depression

According to the official business-cycle chronology, the United States entered a recession in August 1929, two months before that year’s famous stock market crash. Although the crash surely made the slump worse, through late 1930 it still seemed to be a more or less ordinary recession. Then the bank failures began. A majority of economists believe that the banking crisis is what turned a fairly severe but not catastrophic recession into the Great Depression.

How did the banking crisis hurt the wider economy? Largely by creating a credit crunch, in which businesses in particular either could not borrow or found themselves forced to pay sharply higher interest rates. Figure 18-5 shows one indicator of this credit crunch: the difference between the interest rates—known as the “spread”—at which businesses with good but not great credit could borrow and the borrowing costs of the federal government.

The 1930s Banking Crisis and Credit Crunch
Source: Federal Reserve Bank of St. Louis.

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Baa corporate bonds are those that Moody’s, the credit rating agency, considers “medium-grade obligations”—debts of companies that should be able to pay but aren’t completely reliable. (“Baa” refers to the specific rating assigned to the bonds of such companies.) Until the banking crisis struck, Baa borrowers borrowed at interest rates only about 2 percentage points higher than the interest rates the government borrowed at, and this spread remained low until the summer of 1931. Then it surged, peaking at more than 7 percentage points in 1932. Bear in mind that this is just one indicator of the credit crunch: many would-be borrowers were completely shut out.

One striking fact about the banking crisis of the early 1930s is that the Federal Reserve, although it had the legal ability to act as a lender of last resort, largely failed to do so. Nothing like the surge in bank borrowing from the Fed that took place in 2007–2009 occurred. In fact, bank borrowing from the Fed throughout the 1930s banking crisis was at levels lower than those reached in 1928–1929.

Meanwhile, neither the Fed nor the federal government did anything to rescue failing banks until 1933. So the early 1930s offer a clear example of a banking crisis that policy makers more or less allowed to take its course. It’s not an experience anyone wants to repeat.

Quick Review

  • Banking crises almost always result in recessions, with severe banking crises associated with the worst economic slumps. Historically, severe banking crises have resulted, on average, in a 7-percentage-point rise in the unemployment rate.
  • Recessions caused by banking crises are especially severe because they involve a credit crunch, a vicious circle of deleveraging coupled with a debt overhang, leading households and businesses to cut spending, further deepening the downturn.
  • Slumps induced by bank crises are so severe and prolonged because they make monetary policy ineffective: even though the central bank can lower interest rates, financially distressed households and businesses may still be unwilling to borrow and spend. An economy is in a liquidity trap when conventional monetary policy is ineffective because nominal interest rates are up against the zero bound.
  • Central banks and governments use two main types of policies to limit the damage from a banking crisis: acting as the lender of last resort and offering guarantees that the banks’ liabilities will be repaid. In the aftermath of a bank rescue, governments sometimes nationalize the bank and then later reprivatize it. In an extreme crisis, the central bank will provide direct financing to private credit markets.

Check Your Understanding 18-3

  1. Question

    G+b8sUsTuKs66TKdpHxYuPzERoq/V44r8ZDDix17kUkQcyaxPWJqxus4q1H2QV+14ppxElzjpMbe46MaJ7/04KyHQI8N0mPtaRKFxlEF9DVtJSK1igfb+PVArW9LLEaWBNEmiP61Nw0xqfn5m7E+wX8VXKfIKuH7BUS1sWnWdODe9OEzh3yWb0xHwhjbkSPNW1UxyanGrLqoYoXUUA6RVOqs5mL3oc4U01CwB6kN4BcBhO0MzzCbpYilcZe/TWAilnqUkW90Ht9wAXuVjyjPIHuyea9Oq/sX860DFN5T+UKWuLH/NnwesASNKS8hfyuhFpsaTbZtoXeyTWbS
    False. The Federal Reserve was able to prevent a replay of the Great Depression because, unlike in the 1930s, it acted as a lender of last resort to stabilize the banking sector and halt the contagion. But it was unable to significantly reduce the surge in unemployment because the United States experienced a credit crunch and a vicious circle of deleveraging, leaving monetary policy relatively ineffective.

Solutions appear at back of book.