(Note: This is an unedited first draft from my next book: Abolish Money (From Economics)! The text of the book is now complete, and I am in the editing process. I expect to publish it in January.)
- All financial entities that issue short-term financial liabilities (including bank deposits, in case that is not obvious) must ensure that their effective liquid assets are at least the same size as their short-term liabilities (he uses one-year maturity as a cut-off). (In this text, I use “bank” for simplicity, but it must be emphasised that non-bank financial entities are caught up in this regulatory web as well.)
- Effective liquid assets are defined as the sum of the value of firm’s assets after taking into account a liquidity haircut that is defined by the central bank (based on the class of assets). This is discussed further below.
For example, take the classic case of a bank with assets that consist of $10 in balances at the central bank, and $90 in bank loans. If the loans all fell into a category for which the haircut was 50%, the effective liquid asset total of the bank is calculated as $55 ($10 for the reserves, and $45 for the bank loans). The implication is that the bank cannot have more than $55 in short-term liabilities; the remaining $45 would have to consist of long-dated bonds and equity.
(The only part of bank regulation that would also be needed is the regulation of the breakdown between long-term debt and equity. In theory, it should not matter too much, as if the entity falls to a negative equity position, regulators have a year to do a debt restructuring. In practice, regulators are not going to want to have large universal banks holding the economy hostage by threatening to go bust at a bad time.)
Importantly, the “haircuts” are not just a regulatory concept, like asset risk weightings in existing regulatory regimes. The central bank is committed to lend against those assets on demand, with the amount of the loan set by the largely fixed haircut schedule. (The central bank may revise those haircuts, but only at infrequent intervals, such as three years.) The interest rate on such loans would be at a fixed spread to the policy rate of interest.
Full reserve banking (“100% bank reserves”) can be viewed as a special case of this scheme. In full reserve banking, the haircut on all assets other than settlement balances at the central bank and Treasury bills is 100%.
Difference from Bagehot’s “Lender of Last Resort”Such central bank lending is a form of lender-of-last resort operation. However, King observes that there is a difference from Walter Bagehot’s formulation: the central bank should lend freely against good collateral. What we see in practice is that banks “optimise” their balance sheets during the expansion phase of the cycle, and they keep the regulatory minimum amount of unambiguously “good” collateral. When the crisis hits, all they are stuck with is “bad” collateral.
By pre-committing to lend against specific classes of assets at fixed haircuts, the central bank is going to lend against almost any collateral in a crisis (although it would likely rule out in advance fixed income securities it cannot price, or equity securities, by setting the haircut at 100%).
Back to the FutureI have advocated a similar scheme, so I certainly agree with the basic principles behind Lord King’s suggestion. However, I have some reservations about the implementation – I believe that central banks need to embrace this concept even more forcefully. Instead of just being an operation undertaken during a crisis, central bank lending against private sector collateral should be done on a full time basis.
My analysis is not particularly original; my arguments were based on Hyman Minsky’s; for example, he discusses this in Chapter 13 of Stabilizing an Unstable Economy.  (My summary was published in Chapter A.2 of Understanding Government Finance.) Meanwhile, his comments were based on returning central bank operations to how they were undertaken in earlier eras, such as the Bank of England before World War I.
The difference between the two conceptions is that the central bank’s balance sheet will consist almost entirely of discounted private sector assets. (This is sometimes referred to as an “overdraft economy,” as discussed in Marc Lavoie’s Post-Keynesian Economics: New Foundations. ) By necessity, banks (and selected “shadow bank” institutions) would have to go the central bank for short-term financing, and the central bank staff would be forced to follow closely the trends in assets held by the banking system. If the central bank does not like the risk profile taken by banks, it eliminates the short-term financing for the dodgy lending, forcing the banks to either use long-term financing to fund the positions – or stop making the dubious loans.
The central bank will thus always be forced to keep an eye on what the bankers are up to, and nudge the private sector towards less self-destructive paths. We would not repeat the experience of the Financial Crisis, where central banks suddenly woke up to the reality that they had no idea what private financiers had been up to over the past decade.
Of course, there will still be ugly shocks. The reality is that lending standards will always be pro-cyclical; the shifts in “animal spirits” almost entirely defines the business cycle (other than the case of boneheaded policy-induced recessions, such as in the euro area periphery). Central bankers are human, and so they will be sucked into the latest investment fads as well. However, their institutions cannot go bust, and so they will be in a good position to work things out. As long as the private banks survive the crisis, the central bank not be exposed (since the loans are to the banks; losses on collateral only matter if the borrowing bank fails).
It would have been interesting to see how Mervyn King compares his proposal to the analysis of Minsky. In fact, Mervyn King cites Stabilizing an Unstable Economy in The End of Alchemy, so it is not as if he was completely unaware of Minsky’s work (!). My guess is that King only looked at the parts of Minsky’s book that discussed the “Financial Instability Hypothesis,” and ignored the sections on how Minsky wanted to reform capitalism to stabilise an unstable economy.
Monetarism, AgainAlthough Mervyn King does not appear to be a Monetarist, he has incorporated a hidden analytical assumption that mainstream economics picked up from Monetarism. (My comments here are based on Minsky’s observations about Monetarism.) Historically, central bankers were, well, bankers. However, Monetarists were fixated on the magical variable “M” in economic models, and insisted that the only role of the central bank was set the level of “the money supply” in some optimal fashion. Ideally, all discretion would be removed from central bank activity; everything would be rule based. (Professor John Taylor’s arguments about rule-based policy rates are just a variant of this view.)
If the central bank just buys Treasury securities, there is almost no discretion in its decision-making. (The trading desk has limited discretion, but they normally just act to keep bond prices in line with a fitted yield curve, similar to what private sector relative value strategists do.) Deciding what loans to discount, and what haircuts to apply, brings back discretion in a big way.
As a Canadian Prairie Populist (who admittedly lives about 2000 kilometres from the nearest prairie), I understand the political problems with central bankers cutting opaque deals with fat cat bankers. Nevertheless, that is how private sector finance largely works. Banks routinely have to decide which borrowers will have their loans rolled over, and which will end up being restructured (if the borrower cannot find an alternative source of financing). There are markets that are transparent – such as equity secondary market trading, and the futures market – but those markets are used for shuffling existing portfolios, not for raising finance.
Absent a total restructuring of the financial system, it is extremely difficult to avoid central bank staff from making relatively opaque decisions with respect to lender-of-last resort operations. For example, big banks could be broken up, to avoid “too big to fail” issues, and reduce the lobbying power of individual bank lobbyists. At the same time, the Savings and Loan crisis in the United States showed that a bunch of small banks can run over the same cliff in the same way as big banks, and that even relatively small banks can manage to develop strong political connections. (As discussed in Bill Black’s book, The Best Way to Rob a Bank Is to Own One. ) At the end of the day, we have to rely on the professional integrity of central bank staff, and not hope that disembodied “policy rules” can magically make all economic problems disappear.
 The End of Alchemy: Money, Banking and the Future of the Global Economy, Mervyn King, W.M. Norton & Company, 2016. ISBN: 978-0-393-24702-2.
 I have some reservations with this argument. I interpret Bagehot’s definition of “good collateral” in a “good under normal circumstances, but perhaps not during a crisis.” For example, BBB-rated industrial bonds are normally “good collateral,” but might not be viewed as such in the middle of a crisis. I would not view lending against such securities as “lending against bad collateral.” The Financial Crisis was unusual in that the financial system managed to convince itself that some extremely toxic financial structures were “money good,” but one hopes that investors will not be that gullible again for a long time. It makes no sense to ever lend against truly “bad” collateral, such as debt of firms in the middle of a restructuring.
 Stabilizing an Unstable Economy, Hyman P. Minsky, McGraw-Hill, 2008. ISBN: 978-0-07-159299-4. Minsky cites R.S. Sayers, Bank of England Operations (1890-1914), (London: P.S. King And Sons, 1936), a volume to which I do not have access.
 Found on pages 208-209 of Post-Keynesian Economics: New Foundations, Marc Lavoie, Edward Elgar Publishing Limited, 2014. ISBN 978-1-78347-582-7.