Author: Carolyn Sissoko
The traditional role played by central banks in sovereign debt markets generates a risk of fiscal dominance, but now the existence of a central bank ‘put’ has created a problem of financial dominance. Financial dominance refers an environment where financial instruments are designed to take advantage of the central bank ‘put’ and this precludes ‘neutral’ implementation of central bank policy.
This paper sets forth a framework modeling the traditional ‘banking approach’ to central bank liquidity provision and advocates a return to it. The banking approach aligns incentives in the financial system by ensuring that losses are borne by the private sector, not the central bank. In order to re-establish the banking approach to liquidity this paper recommends (i) replacing the current collateral based derivatives and repo system with bank lines of credit and constraints on banks’ ability to sell collateral into an illiquid market; (ii) requiring that all monetary run-risk intermediaries, such as money market funds and finance companies, be brought onto bank balance sheets; and (iii) stricter regulation of BBB rated holdings for investment funds (or non-monetary run-risk intermediaries) when they are prohibited from holding below investment grade assets. These reforms must be accompanied by a clear policy that in the event that any bank requires re-capitalization by the government, existing shareholder interests will be wiped out, and ownership will be transferred to the government.