by Don Alexander, MBA
Associate, RSD Solutions Inc.
The recent newspaper headlines have included such items as “S&P Warns on 15 Euro-Zone Nations”. Other topics include the size of a temporary bailout fund may rise to $1.0-2.0 trillion to stabilize financial markets and the European banks may eventually need $150-200 billion of new capital to offset potential losses on their holdings of sovereign debt. The point is that the cost of stabilizing financial markets has risen dramatically – it might help to understand why policymakers delay decisions and provide some lessons for risk management. A recent communique “Why the ECB refuses to be a Lender of Last Resort” (VOXEU, Paul de Grauwe, Nov. 28th) looks at some of these issues.
The euro is under intense pressure, as it has a number of weeks to save itself, as a number of institutions prepare for a potential restructuring or its actual demise. Analysts are calling for the ECB to act as lender of last resort for the Eurozone bond market. Why does the ECB hesitate to act as a lender of last resort? If a central bank is to do so, it must evaluate the costs and benefits of its inaction of not providing last resort buying service.
The cost of inaction arises from the risk that inaction will lead to a collapse of the banking system. The benefit of inaction is the avoidance of future moral hazard risk which is beneficial to long-run the banking system stability. When evaluating the cost and benefit, the time horizon which these costs and benefits materialize matters a great deal. The cost of not providing lender-of-last-resort is almost instantaneous, since bank liabilities are short-term. The results of inaction are likely to be realized quickly while the benefits will be realized sometime in the future, possibly far in the future.
The asymmetry of the timing costs and benefits helps explain central bank behavior. Viewing the government bond markets, the sovereign debt crises occur at a much slower pace than banking crises. When facing a sovereign debt crisis, the conservative central bank view will weigh the long-term importance of reducing moral hazard unless the banking system is in immediate danger of collapse.
The implication is ECB inaction unless the cost is immediate and clear and the sovereign debt crisis leads to an immediate banking crisis. The implication of ECB caution suggests two results: this means the amount of the liquidity/aid the ECB eventually may have to inject into the banking system is likely to be far higher than the amount required to stabilize government bond markets and a banking crisis will also trigger a deep and long-lasting Eurozone recession.
The ECB may well be behaving rationally, but it is both foolish and dangerous. The lessons for risk management – address potential risks or pay the consequences.
For more on this follow the link: http://www.voxeu.org/index.php?q=node/7352
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