Central bank insurance could prevent crises

Central banks should insure bank assets against systemic crises to avoid another financial panic, according to a proposal presented at the Federal Reserve's Jackson Hole symposium last week.

Ricardo Caballero and Pablo Kurlat of the Massachusetts Institute of Technology called for central banks to sell tradable insurance credits (TIC) to banks. In normal times, TICs would be inert: banks would be required to hold a certain TIC-asset ratio, and could trade excess TICs among themselves. As a crisis became more likely, central banks could declare that these TICs could be attached to certain classes of assets – for example, in the subprime crisis, the central banks should have allowed banks to attach TICs to residential mortgage-backed securities, they suggest – effectively converting into central bank-backed credit default swaps (CDS), which would protect the value of the asset to which they were attached.

In their paper, The surprising origin and nature of financial crises: A macroeconomic policy proposal, Caballero and Kurlat argue TICs would have been effective against the current crisis. The process would be markedly faster than informal offerings of insurance to banks, as it would be in place in advance, rather than being put together as the crisis developed. Ad hoc asset-insurance schemes, such as the UK Asset Protection Scheme and the US Public-Private Investment Program, were effective, but "there is always a danger that political considerations emerging during the crisis will delay or prevent intervention, exacerbating uncertainty and possibly missing the early window of opportunity to contain the crisis," the authors wrote.

Furthermore, they argued, their existence would help to limit panic during a financial crisis, thereby preventing a boom in CDS prices from debilitating the financial markets.

Additionally, during a panic, the TICs themselves would rise in value, as the likelihood of their conversion and attachment increased, helping to offset the damage to banks' balance sheets from falling asset values.

However, in discussion, Harvard economist Kenneth Rogoff pointed out that, given recent events, major banks now expected to be bailed out by central banks in a crisis, whatever their own degree of culpability: "In a crisis, would the government really shut down financial firms that did not take out enough insurance, or even those firms that did not take any insurance at all?"

His criticism was echoed by Charles Goodhart, an economist at the London School of Economics. ""During this crisis most central banks have been steadily driven from their comfort zone of only providing liquidity to a limited set of (core) banks by lending against top-quality assets for short periods, towards lending to a widening range of financial institutions against almost any grade collateral at ever-longer maturities," he said. "This genie cannot be put back in the bottle. Central banks cannot expect in future to enforce good behaviour in bank asset management by some constructive ambiguity on whether to withhold liquidity assistance."

Goodhart continued: "Their actions have spoken louder than words. Just as it is the métier of God to have mercy on sinners, however heinous the sin, so it is the métier of central banks to provide liquidity to systemic financial institutions, however dubious the assets on their balance sheets."

The chairman of the Federal Reserve, Ben Bernanke, argued the US required more varied policy measures to the financial crisis than other countries due to its exposure to financial markets and non-bank financial institutions. He also discussed the importance of liquidity risk management, along with capital adequacy and credit and market risk management, in limiting further crises.

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