Shadow banking and central bank liquidity support
April 4, 2012
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Global liquidity provision is highly pro-cyclical. The recent financial crisis has resulted in a
flight to safety. Severe strains in key funding markets have led central banks to employ highly unconventional policies to avoid a systemic meltdown. Bagehot’s advice to “lend freely at high rates against good collateral” has been stretched to the limit to meet the liquidity needs of dysfunctional financial markets. As the eligibility criteria for central bank borrowing have been tweaked, it is legitimate to ask how elastic the supply of central bank currency should
I address this question in a new Working Paper from Levy Institute: Shadow banking and the limits of central bank liquidity support. The paper review the recent expansion in central bank liquidity support, including their collateral polices, and then suggests that central banks should not unconditionally supply liquidity to a banking system that is growing uncontrolled. Stricter controls are required unless central banks again will have to underwrite dysfunctional markets.
The paper also provides input to the ongoing Krugman – Keen discussion on banking. See especially section 6 on excessive global credit and section 7 on A new view of banking.