♪ [music] ♪ [Alex] In our earlier videos, we discussed how the Fed uses
its control of the money supply to increase or decrease
aggregate demand. The Fed, however,
has another tool at its command. In a panic, when depositors
are running to their bank to withdraw their money, when lenders are refusing to lend, when fire sales
are burning down the house, when no one knows where to turn, they turn to the the Fed,
the lender of last resort. Panics can be especially dangerous because in the right circumstances
they can be set in motion by the tiniest of tremors, and yet they can quickly
grow and spread so that they become self-fulfilling. A panic, for example — it might start with a simple rumor that a financial institution
like a bank is insolvent. An insolvent institution is one
with more liabilities than assets. If depositors and lenders fear
that their bank is insolvent, they’ll quickly rush
to withdraw their money, knowing that the last people
to withdraw — they’ll be the ones
holding the bag. The rumor could even be false. Perhaps the bank has
lots of assets, but its assets are illiquid. An illiquid asset is one
that’s worth a lot in the future, but it can only be sold today
at a much lower price — perhaps because the asset
is difficult to value, and it takes time
to find the right buyer. Now think about banks. The main assets
that banks hold are loans — loans that are difficult to value, and that won’t pay off
until the future. So banks hold lots
of illiquid assets. And if the bank is forced
to liquidate early to pay its depositors or lenders, that can create a lot of waste. Banks establish
long-term relationships with their customers. Consider a software project,
for example. The developer has explained
the project to the bank and they get funding. They finish half of the code
and they need another loan. It makes sense
to go back to the same bank. No one else will understand
the project as well. If that bank
can’t fund the project, the whole thing will probably die! Not only will it be hard to explain
the idea to other investors — those investors may fear
an adverse selection problem. Why isn’t the bank
that knows the project the best making the loan? It’s suspicious. A bank run
can break the continuity, which is necessary to fund
high-value, long-term projects. The depositors, however — they can’t really tell
whether the bank is really insolvent or just illiquid. And any hint
that the bank isn’t ready to pay everyone on demand — that could make the panic spread. This is where deposit insurance
and the Federal Reserve come in. Deposit insurance tells depositors,
“Don’t worry! Even if the bank is insolvent,
you’ll still be paid.” And because of that guarantee,
there’s no run. And the bank isn’t forced
to stop funding the software project until it’s finished. When deposit insurance
isn’t enough, or when the financial institution
isn’t covered by deposit insurance, then the Fed can step in
as the lender of last resort and provide the bank enough cash to pay off any depositor
that wants to be paid off — again, without requiring the bank
to liquidate its assets too early. Traditionally, the Fed lent
to solvent but illiquid banks — to get them through
a temporary squeeze — and it wound down insolvent banks. But in a panic, the Fed may also
have to lend to insolvent banks. It may have to bail them out. The problem in a panic
is the problem of systemic risk. In a panic, if one
financial institution goes down, it’s likely to take others with it,
like dominoes. The bankruptcy of one
insolvent financial intermediary could take illiquid but solvent institutions
down with it. So the Fed sometimes
has to bail out some insolvent banks in order to protect
the entire system. At the height of the 2008-2009
financial crisis, for example, the Federal Reserve, the Federal
Deposit Insurance Corporation, and the U.S. Treasury stepped in
to support the financial system on an unprecedented scale. Deposit insurance,
which traditionally had been limited to $100,000
for each bank account — in effect, it was extended
to all accounts, increasing the amount insured
by some $8 trillion. In addition, the U.S. Treasury
guaranteed trillions of dollars in money market funds, and the Fed also became
the lender of last resort to the commercial paper market. The Fed also went
from lender of last resort to owner of last resort when it assumed
a majority ownership stake in the insurance company AIG. Why? Because the bankruptcy of AIG
would have threatened many other
financial intermediaries, and the Fed wanted
to create a line break to stop the dominoes
from toppling over. Finally, the U.S. Government
stepped in as a lender of last resort and partial owner
of General Motors when GM couldn’t get funding
from banks. But here is the problem.
What would you do if you were told that
you could invest in anything, and the government would step in
and bail you out if you failed? It’s pretty clear —
you’d take on more risk, since you would get
the benefit of the upside, and the government would be left
with the downside. This is the fundamental problem
that the Fed faces. When individuals
or institutions are insured, they tend to take on
too much risk — the problem of moral hazard. Big financial institutions —
too big to fail? They have too little incentive to make responsible
financial investments. This, in part,
is also why the Fed has the role of regulating banks. To minimize this reckless behavior, the Fed imposes conditions on what assets
the bank can and must hold. Regulations like this, however —
they have costs of their own, including a more bureaucratic
and less flexible banking system. Limiting systemic risk
while checking moral hazard — that’s the fundamental problem
the Fed faces as a bank regulator. And today,
the shadow banking system does more lending
than the traditional banks. And in addition, the financial system has become
more complex and intertwined as financial assets are packaged,
subdivided, bought and sold more than ever before. As a result, the Fed’s lender of last resort
and regulatory functions have become much more important
and much more complex. The Fed is trying to steer a course
between these two problems. If a panic occurs, it may be best
to bail out some firms — even bad actors — to protect the system. And yet, the promise
to bail out firms in a future panic — that encourages risk-taking, and it increases the probability that a panic will happen
in the first place. It’s not obvious
that the Fed has the tools to steer clear of both problems. This is the great dilemma
of modern monetary policy. [Narrator] You’re on your way
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