Playing to be the last bankrupt

In the absence of a leverage enforcement, each bank plays to be the last bankrupt.

The historical experience shows that the first filers may not be rescued. Chance of bailout rises as a bank remains solvent until the government steps in.

In a severe recession, even the most resilient banks could fail if they were let play to be the last bankrupt. Authorities should change the game rules by enforcing banks to expand credits.

Authorities can heat an overcooled economy by enforcing credit expansion.

Monetary policy is desperate

Shocked by COVID-19, economies dramatically contract. Monetary policy is impotent at the zero lower bound. Unconventional tools, quantitative easing and forward guidance, prove less effective this time since long-term interest rates are lower in 2020 compared to 2008. In these circumstances, macroprudential policy can equip central banks with the tools to boost spending via the banking channel.

Macroprudential framework has been so far deployed to cool economies down. For this purpose, authorities have formulated capital buffers. Thus, banks' leverages were constrained by their equities. Capital requirements have proved effective to contain over-leveraging. Likewise, authorities can also heat an overcooled economy by requiring banks to raise leverage. Banks' expansion of credits serves a growing expenditure which would raise business revenues and, thus, enhance employment. A higher disposable income would prop up bank capitals via alleviating delinquencies.

Banks must collectively act in recessions

Unfortunately, the current situation is totally the other way around. In the absence of a leverage enforcement, each bank plays to be the last bankrupt. Via shrinking credits to insolvent borrowers, they protect their capital against delinquencies. Solvency is a relative term in recessions. Most firms become insolvent due to plummeting revenues. In the absence of finance, those firms go bankrupt.

Banks are aware of the negative consequences of credit contraction on spending. Households cut expenses and businesses lay off workers to be able to serve net debt. As disposable income falls due to shutdowns, layoffs and depressed spending, surging delinquencies would jeopardize bank capitals. In this equation, the best scenario is a bailout for banks. Historical experience shows that the first failures may not be rescued. Chance of bailout rises as a bank remains solvent until the government decides for a capital injection.

Even the most resilient bank could fail in the spiral of credit rationing and surging delinquencies if it is allowed to individually respond to a recession. Central banks were established as a need for collective action in crises. Not much changed since 1907 when JP Morgan locked banks into his library until they agreed on a recovery fund. Later, central banks undertook JP Morgan's role. Today, central banks still need the authority to force banks to credit expansion in recessions. Thus, the spiral of higher delinquencies magnified by credit rationing can be broken.