How central banks end crisis (and create the next ones?)

It is all about operating in secrecy. Central banks end crisis by making sure no one knows what you are doing and who are the partners (Banks and FIs) in crime.And general public is made to feel that as if there is some magic going on.

Gary Gorton and Guillermo L. Ordoñez in this paper explain the importance of secrecy in ending crisis:

To end a financial crisis, the central bank is to lend freely, against good collateral, at a high rate, according to Bagehot’s Rule. We argue that in theory and in practice there is a missing ingredient to Bagehot’s Rule: secrecy. Re-creating confidence requires that the central bank lend in secret, hiding the identities of the borrowers, to prevent information about individual collateral from being produced and to create an information externality by raising the perceived value of average collateral. Ironically, the participation of “bad” borrowers, with low quality collateral, in the central bank’s lending program is a desirable part of re-creating confidence because it creates stigma. Stigma is critical to sustain secrecy because no borrower wants to reveal his participation in the lending program, and it is limited by the central bank charging a high rate for its loans.

Further:

Secret lending is the basis for the discount window, a facility used by many central  banks around the world. Even before the Federal Reserve came into existence, the private bank clearinghouse lending during banking panics in the U.S. was done in secret, and individual bank-specific information was cut off by the clearinghouse. Further, the assets of member banks were essentially pooled by issuing a new claim, the clearing house loan certificate, which was a joint claim, further hiding the identities of borrowing members. (See Gorton and Tallman (2014)). Secrecy is pervasive in central banking lending programs and seems to be an implicit part of Bagehot’s rule.

Bagehot did not mention secrecy because “. . . a key feature of the British system, its in-built protective device for anonymity was overlooked [by Bagehot]” (Capie (2007), p. 313). Capie explains that in England geographically between the country banks and the Bank of England was a ring of discount houses. Also, see Capie (2002). If a country bank needed money, it could borrow from its discount house, which in turn might borrow from the Bank of England. In this way, it was not known where the money from the Bank of England was going.

And of course this sows the seeds of the next crisis too. The banks know that they shall be bailed out and even better no one will even know their names..

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