Abstract
This chapter will discuss the role of central banks in terms of financial crisis management based on the lessons learned from the failure of the US monetary authorities’ financial crisis management strategy during the financial crisis of 2007–09. The role of central banks in prudential policy explained in the previous chapter is a role they fulfill during normal times , but this chapter will discuss their role in times of crisis.
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Notes
- 1.
‘The US authorities’ includes government institutions such as the White House, the Treasury, and, FRS including high-ranking officials of such institutions such as the President, Secretary of the Treasury, and Chairman of the FRS.
- 2.
However, Kikuzawa (2007) suggests theory that integrates behavioral economics and agency theory (behavioral agency theory).
- 3.
With regard to behavioral economics that is applied as a basis for strategy of the mental world under behavioral new institutional economics , only prospect theory is used in Kikuzawa (2009, and his other works).
- 4.
This is a concept similar to Williamson’s (2008) “remediableness criterion.” This criterion is in contrast to the Pareto criterion. Scheme change accompanies transaction cost that is necessary for negotiation and implementation. If such transaction cost is extremely high, the system will not see any improvement even if the new system is efficient. However, this criterion only compares decrease in production cost and increase in transaction cost , and does not consider decrease in psychological cost as in behavioral new institutional economics .
- 5.
Strictly speaking, capital injection was decided in the form of guarantee when the US Government placed Fannie Mae and Freddie Mac under its control on September 7, 2008 and when the Treasury provided full value guarantee to money market funds on September 19, 2008.
- 6.
The specific liquidity support measures during the period specified by the FRS (Federal Reserve Annual Report 2009) were (a) lowering of the lending rate at the discount window and easing of screening standard (August 17, 2007), (b) establishment of the Term Auction Facility (December 2007), (c) swap line agreement with the European Central Bank and Suisse National Bank (December 2007), and (d) launch of the Term Securities Lending Facility (March 11, 2008). Also, an FRS loan to Bear Stearns (March 2008) is mentioned in the Report as an example of its support to individual financial institutions.
- 7.
Thus, until the enactment of the Emergency Economic Stabilization Act in October 2008, no clear capital injection had been made. That is, injection was not ‘too little’ but nil.
- 8.
For example, Chairman Bernanke (2009b) explains that “the company’s available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs.”
- 9.
After the collapse of Lehman Brothers , the FRS adopted market liquidity providing measures. Specifically, creation of the Commercial Paper Funding Facility to reduce turmoil in various markets such as the CP markets and agency bond markets (bonds issued by government sponsored enterprises, i.e., Fannie Mae, Freddie Mac) as well as direct purchase of such agency bonds.
- 10.
The Wall Street Journal (August 26, 2009) said “As economists Anna Schwartz and John Taylor have noted, Mr. Bernanke misdiagnosed as a liquidity crisis what was principally a bank solvency problem . This is one reason his easing did little to stem the panic throughout 2007 and 2008. A steadier monetary hand might well have avoided autumn panic.”
- 11.
Also, in testimony on February 14, 2008, “Chairman Bernanke exhibited cautious business sentiment and stock prices plunged sharply” (Nikkei Shimbun, evening edition, February 29, 2008 <translated from Japanese>).
- 12.
Wall Street Journal (February 29), “Fed Chairman Bernanke in his testimony noted that it wouldn’t be surprising if there were some bank failure due to the current market crisis.”
- 13.
Other similar terms include ‘band wagon effect,’ ‘herding phenomenon,’ ‘mob psychology.’ So-called ‘systemic risk ’ also includes the spillover of risks through the psychology and emotions of depositors, investors, and financial institutions in addition to risks related to loss of confidence in payment systems and is therefore used in a similar context as contagion effect .
- 14.
The US authorities’ failure to make an accurate forecast which led to the failure of neoclassical economic-based strategy may be due to lack of knowledge on the contagion effect and therefore they could not forecast a rapid and large-scale plunge in market liquidity and deterioration in financial institutions’ business conditions.
- 15.
There are many theories that explain the contagion effect and systemic risks. For example refer to Schoenmaker (1996).
- 16.
Taylor (2009) analyzes in detail the events that occurred before and after the Lehman shock and the market turmoil that followed. However, he does not touch upon the rejection of the bill by Congress. This may be because he wanted to emphasize the fact that explanation of the bill by Treasury Secretary Paulson and Chairman Bernanke to Congress invited market turmoil.
- 17.
‘Liquidity shortage’ is a temporary shortage of funds. If given necessary time to sell assets etc., a financial institution in such a situation would not fail. To the contrary, a ‘solvency problem ’ means that a financial institution has excess debts and in the sense that time cannot solve a fund shortage, it is insolvent. A solvency problem can only be improved by capital injection.
- 18.
Similar to ‘capital,’ the term ‘public funds’ can also be used. However, ‘public funds’ is a vague term encompassing all instruments explained here, and therefore we do not use it.
- 19.
‘Cash liquidity ’ refers to cash and deposits that could be used to make payment, and ‘market liquidity ’ to the ease of selling assets in financial markets. For details of the difference, refer to Chap. 15 of Shirakawa (2008a).
- 20.
An example of limited provision of risk money by a central bank is when the central banks of the US, Europe, and Japan adopted unconventional monetary policy and bought high risk financial assets.
- 21.
A central bank’s capital is its net assets comprised of capital stock (as discussed in Chap. 2, Sect. 2.5), provisions, and reserves.
- 22.
Milton and Sinclair (2011) discuss these issues in detail from various standpoints.
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Oritani, Y. (2019). Role of Central Banks in Financial Crisis Management. In: The Japanese Central Banking System Compared with Its European and American Counterparts. Springer, Singapore. https://doi.org/10.1007/978-981-13-9001-2_6
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DOI: https://doi.org/10.1007/978-981-13-9001-2_6
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