Must-Read: James Hamilton: Too Systemic to Fail

Must-Read: One of the pieces of the Bagehot rule for dealing with a financial panic is the penalty rate piece: the managers, option holders, and shareholders of institutions that need the lender of last resort should not profit thereby. Lender-of-last-resort loans should be made at painfully high interest rates. And if the institution is too close to insolvency to stand a penalty rate, the right policy is for the central bank to TAKE THE EQUITY.

I have never heard an explanation from anyone in the Treasury or the Federal Reserve for why so little was done to implement this piece of the Bagehot rule in 2008-2009:

James Hamilton: Too Systemic to Fail:

Bryan Kelly at the University of Chicago, Hanno Lustig at Stanford and Stijn van Nieuwerburgh….

The authors constructed an option-pricing model that incorporated this perception on the part of option traders which allowed them to estimate parameters of the perceived policy to be able to explain the observed option prices. They then used this model to ask, suppose there had been no government guarantee, but you wanted to buy an insurance policy covering the entire financial sector that would function the same way. They concluded that such a policy would have cost $282 billion… meaningful effects of government guarantees on the value of equity and equity-linked securities.

There are those who claim that the government’s goal was to protect the banks. I do not share that view, and maintain that instead the government’s goal was to prevent collateral damage from a financial-sector collapse. The trade-off all along was to try to make sure that as much of the out-of-pocket costs as possible were paid by bank owners and management while minimizing collateral harm to the non-bank public. Whether we found the right way to balance those trade-offs is something that will still be debated.

But I think we can all agree that what the government did was a pretty big deal.