Abstract
Central Banks have traditionally rescued banks only indirectly by monetizing or purchasing government debt sold to finance a bailout. However, over the last few years, monetary authorities have started using less conventional methods to directly restore bank viability. These methods include quantitative and qualitative easing which compliment the more traditional method of debt monetization. The present paper studies the effectiveness of these bailout strategies and articulates some original policy options now available to central banks with currency targets.
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Notes
Llewellyn (2000) argues that effective regulation (both internal and external to the firm) is an essential part of a stable and robust financial system.
Melitz (2010) discusses how much regulation is optimal.
Here a bailout occurs when poor quality assets are removed from bank balance sheets. However, a bailout may be done through an injection of capital such as the purchase of bank stock. Both bailout techniques will improve bank capital ratios and reduce bank risk. The model’s results are robust to both bailout techniques.
The central bank may also indirectly bailout banks, by purchasing long-term government debt from the market (i.e., undertake a “riskless” quantitative easing). This option will not be explicitly considered here.
For ease of exposition, the paper takes the traditional (i.e., simplistic) view towards money creation and assumes that the central bank fully controls the money supply. Recent papers take a financing approach to model bank behaviour and assign banks a larger role in money creation. Further research might study how central bank bailout techniques affect bank behaviour and hence money creation.
Another unconventional asset that central banks have started holding is long-term government debt.
Alternatively, the central bank may purchase long-term government debt and undertake a “riskless” quantitative operation. However, in both purchases of government debt, the money supply increases; and the integrity of the central bank’s asset portfolio is maintained as long as government debt maintains its risk-free credit rating.
In addition to purchasing short-term government debt, the central bank could purchase long-term government debt. Central bank purchases of short-term government debt are traditional monetary easing while purchases long-term government debt, are “risk-free” quantitative easing. This option will be discussed in the conclusion.
As in “first generation” crisis models (see for example Krugman (1979). Rmin may be made a function of the risk premium or size of the crisis without any loss of generality.
For simplicity, no distinction is made between high powered money and money created by banks (i.e., M1 or M2).
The risk premium can be thought of as the excess risk of depreciation caused by bank risks that would force the government to drop the peg.
It is not unreasonable to believe that Z and/or ρb may be negatively related to output. However, because the model is not dynamic and we are interested in articulating the options available to a central bank given that a banking crisis has hit, we leave the model as simple as possible. Z can be made a function of output without any loss of generality.
Here risk is assumed to be isolated to the banking sector. However, the model can be broadened to include other sources of risk. For example, in the US bank bailout of 2008 a capital injection into the private sector was required to reduce the risk premium of corporate loans and other fixed income securities held by banks.
A bailout could also be engineered through purchases of bank equity. Both purchases of equity or risky-assets will improve bank capital levels and solvency.
This last qualitative easing bailout strategy is obviously only available if central bank risk-free domestic assets are sufficient to purchase all of the banks’ bad investments.
Here we do not address the complete Chinese bailout but only a particular capital injection that was engineered using foreign exchange reserves. The entire bailout, which started before 2003 and continues to this day, was much larger.
Acharya et al. (2014) illustrate that bailouts increase sovereign risk and therefore weaken the financial sector by eroding government guarantees. They confirm the theoretical relationship for European sovereign debt.
A qualitative easing strategy will have the same effect if public debt is risky.
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The paper has benefitted greatly from the comments of three anonymous referees.
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Miller, V., Vallée, L. Unconventional Bank Bailouts in Fixed Exchange Rate Regimes. Open Econ Rev 27, 39–49 (2016). https://doi.org/10.1007/s11079-015-9371-y
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DOI: https://doi.org/10.1007/s11079-015-9371-y