I was interested to discover that Marshall Auerback of the American think tank the Levy Institute, has recently written an article in which he suggests that Central Banks are in effect really insurers to private banks. And all by way of Walter Bagehot, who I discover was not just an authority on the UK Constitution, but also one on banking!
[Central Banks are] uniquely placed to make the Credit Default Swap a credible instrument, as [they] can always create the dollars required to make good the payment in the event of default (or financial accidents). But for the Credit Default Swap (CDS) system to work going forward, the Fed (or any other central banker/dealer of last resort) has to “charge” the right premium to reflect the risks being undertaken by the parties who enter into a contract to buy and sell the CDSs. And if that means charging such an extortionate premium that the underlying activity (or event) isn’t undertaken, so much the better for financial stability.
He goes on to mention that most governments show, as is well-known, a greater or lesser degree of regulatory capture, and
The degree to which this insidious tendency toward accommodating, rather than seriously regulating, obviously impacts on the ability of the central bankers to act credibly as dealer/counterparty/insurer of last resort …. There is a theoretical elegance to the “dealer of last resort” concept, and it also works with the grain of the existing financial architecture (therefore being less disruptive). But it won’t work if the “gamekeepers” continue to let the animals run riot. And if the world’s monetary authorities fail during this next crisis, the preservation of the prevailing financial architecture will become politically unsustainable.
Yet the idea of insurance and actually charging the right premium is one, that, although the author doesn’t seem to take it literally, could set a course that would short circuit regulatory capture.
My suggestion would be simply to make banking (including shadow banking) illegal, unless it is insured by the Central Bank. The Central Bank would charge an insurance premium and this would reflect their view of how dangerous the insured financial activity was to the financial system. It would also force banks to explain their products to the Central Banks in detail – to do otherwise would, after all, render that activity illegal and therefore any resulting contracts unenforceable. This requirement would have prevented the ignorance of what CDSs were, and so also any other wizard scheme that banks, or shadow banks, are likely to devise – as in due course they undoubtedly will – would have to be fully explained to the Central Bank in order that they could charge the appropriate premium.
It would probably require a partially new set of skills on the part of Central Banks but it would also give them a proper area of responsibility – something to justify their existence, an existence, for which there seems little obvious purpose at the moment. Faffing and pontificating on quarter per cent interest rate changes really deceives no one. In fact currently the Bank of England’s role in the financial system is really at a loose end. True, they produce Quantitative Easing but this is effectively a joint decision with government and, were it not for perverse EU rules, this would be clearer.
The Bank of England has been creating money since 1694. Requiring them to become insurers could be the first major change since gold lost its shine. True, as the sole insurer for any UK banking activity, it would be a monopoly provider but then it is the monopoly provider of the government’s money anyway. It could just as easily supervise the banks with compulsory, quasi commercial insurance. Indeed it’s overall effect on banking profits might be the equivalent of a seigniorage tax but with the administrative advantage of including banking direction and supervision at the same time, and all by calculating the premium in the City’s favoured resource, money.
So this gives ‘The Bank’ a proper role and gives a reason for the private banking fraternity to feel important, without allowing for reckless behaviour to generate even more reckless profits.
Couldn’t this make the City more of the service that we really need it to be?