These posts have spoken earlier about the Sub Prime Crisis and how bearish Central Bank made sure we remained insulated from the Crisis. ( how far the De Coupling theory stays true is anyone's guess however!). the Sub Prime Crisis is a Black Swan event and like all Black Swan events, it has brought winds of change in public policy in general and banking regulation in particular. it is time that we reflect on these winds of change and so this post I revisit a related issue;
Should Central Banks act pro-actively to save banks and other Financial instiutions from goin down under? Are there good reasons to intervene and inject liquidity in a failing bank? The answer to the first question till last year would have been a straight No, but after the battering systems received last year, the present system seems to be leaning towards interventionism.
So should we have a system where the Bank Of England or the Reserve Bank intervene and inject liquidity, the moment it sees a bank is in the red? or should we have a system where decisions are taken by Central banks on a case to case basis, intervening only when it foresees that failure of banks has systemic effects. It is interesting to note that the Central Banks Of England and United States till very recently followed a " systemic effect" intervention policy in keeping with the laissez faire nature of the economy in those states while bank regulation in our Country has been based on a multi factor test, inter alia including Depositor interest and public interest and stability of banking system.( These factors cannot be simulataneously balanced; indeed some are antithetical to each other. for example, a particular bank might not be systemically important and so it might not be in public interest to bail it out; however acting in public interest here is directly prejudicial to depositor interest as they stand to fail if the bank is not protected).
the recent Crisis has however as i earlier pointed out brought out interventionist thought in laissez faire thinking.( See how Mervyn King did a volte face and decided to bail out Northern Rock; his early speeches were an eulogy to " systemic effect intervention").
My understanding however is that this change in policy does not augur too well for the Economy. the Economics of bail out suggests that the tax payer pays for share holder apathy. and a sustained policy therefore subsidises risk taking by unscrouplous bank Boards and incentivises further apathy by the share holders. In the long run , market discipline suffers and no one is happier. Rather all Central Banks should return to the " systemic intervention" plank and restrict their altruism to that factor alone. that way owners will monitor banks effectively, agents will have less incentives to self deal substantially reducing agency costs.
It is not my case that the intervention policy is wrong; it is however emphatically my case that it must only be followed this one time; till the crisis is over.
Darwin was not a evil man was he?