The Lender of Last Resort: Why We Need Central Banks
For at least a few hundred years, economies around the world have used short-term loans as a viable source of funding for both Wall Street and Main Street.
For example, putting your money in a bank isvery much like lending to that bank for one day. As long as you don’t withdraw your money, you are effectively choosing to roll over the loan again and again. The bank takes this daily loan and turns it into longer-term loans like mortgages. This short-term and long-term mismatch creates a vulnerability in the financial system. Bank deposits are only one form of short-term financing used in the economy. Businesses use commercial paper programs (short-term loans from investors) and have set maturity dates on their debt creating a need for them to refinance large sums as they come due. This creates further fragility in the system as businesses rely on the availability of new loans. What happens when this fragility starts to show its cracks? In the latter part of 1907, before the Federal Reserve System had been established in the United States, Fitz A. Heinze and his affiliates tried to manipulate the stock price of United Copper in hopes of making a substantial profit. Buying large amounts, they pushed the price higher and higher in hopes of getting the price high enough to force those who had bet against it (short sellers) to buy it back from them at a higher price. If things worked according to their plan, Heinze and his affiliates would benefit immensely. Fortunately (depending on who you are rooting for), this failed miserably as most short sellers found other means of protecting themselves. Heinze and his affiliates suffered huge losses as the price of the stock plummeted. As this seemingly insignificant event was happening, a shock started to reverberate throughout the American financial system. Heinze and Morse used uncollateralized loans from a few trust companies to fund the purchases they were making. These trust companies would often make one-day loans to Wall Street traders so they could buy stocks with the expectation that they would secure another form of financing before the end of the day using thestocks they purchased as collateral. This two-step process occurred because chartered banks were not able to lend without collateral. It was a classic cart-before-the-horse situation. At the time, there was no deposit insurance. If you had your savings at a bank or a trust company and they went bust, you could lose everything. Given the losses incurred by Heinze and Morse, depositors at the trust companies who lent to them feared their savings could be at risk and a bank-run ensued. This was the kindling that ignited a fire of bank-runs on similar institutions in New York over the coming weeks. This may also seem insignificant, but the bank-runs on trust companies started to bleed into the rest of the financial system, causing banks to tighten lending conditions. As interest rates rose and lending became harder to attain, the economy started to faulter. In 1908, industrial output fell 17%. Those who relied on short-term financing fell under significant pressure andbanks around the world started to fail as the entire global financial system felt the ripple effects of a few poor choices. Thanks to the work of the American banker, J.P. Morgan, some additional cash was put in the system so loans could continue to flow, improving the situation slightly. However, confidence from depositors required some courting. It took until 1910 to restore the economy to its previous level of output and for loans to be easily attainable. J. P. Morgan tried to do what central banks do today, but he did not have the power he needed to put legs under the economy, despite serving a crucial role in the recovery. This made the panic of 1907 (as it would later be labeled) one of the key catalysts for the Federal Reserve Act of 1913. The financial system requires confidence to work smoothly. When that confidence starts to waver, lending dries up and businesses struggle to stay afloat.The central bank, however, acts as the lender of last resort and is willing to inject money into the financial system when it is needed most. This doesn’t solve every problem an economy may face, but it certainly inhibits some of the larger shocks they would encounter otherwise. This writing is for general information purposes only. It is not intended to provide legal, accounting, tax or personalized financial advice. For complex matters you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments.
Robert Currie, CFA is an Associate Portfolio Manager with Louisbourg Investments. Submit your comments or questions to Robert.Currie@louisbourg.net.