Friday, August 24, 2007

Should central banks save markets?

Central banks have been pumping funds into the markets in order to stabilise conditions. This troubles many people. Should central banks being bailing out failed institutions such as hedge funds that had taken foolish risks?

Well, no. Central banks may have to save banks because bank failure can pose systemic risk. The others can go to the wall. The difficulty is telling whether the problem at non-bank institutions is a liquidity problem or a solvency problem. It makes sense to make liquidity available to institutions at a time when market sources of liquidity dry up. If banks don't want to give money or to each other or to hedge funds because of panic conditions, central banks should.

But when prices are unstable, how on earth does the central bank determine whether institutions are insolvent or merely illiquid? Many of the institutions themselves don't know what their asset prices are- Bear Stearns kept telling investors in its hedge funds for a long time that it did not have a correct valuation.

So, there is a practical problem here. But there is broad acceptability now as to the conditions under which central banks should intervene. I dwell on this in my ET column, Central banks on a tightrope.

1 comment:

Krishnan said...

The WSJ has a piece today about how what we are facing today is due to what the US Fed did earlier ... with the interest rates being kept low for a very long time, too much credit - and thus excessive risk taking ... When the going was good, people made money ... So, yea, a tight rope - how does one not allow the entire system to fail while letting a few segments fail ... there is real danger to reinflating the bubble as it were