As discussed in my previous post, the biggest problem with allowing SIFIs to post collateral to one another is that it discourages them from restricting credit to banks that are poorly managed. By discouraging normal market forces from working to limit the growth and interconnectedness of bad banks with the rest of the financial system, a collateralized interbank lending regime places an enormous burden on regulators to both identify and shrink a bank that has deep connections with the rest of the financial system. Arguably collateralized interbank lending places an impossible burden on regulators.
The second major problem with shifting from a system of unsecured interbank lending to a collateralized banking system is that in the process of purging the money supply of unsecured debt, the money supply may well have to shrink to the size of the collateral base. Precisely because the shift to collateralized interbank lending creates strong contractionary pressure on the money supply, there is a call for governments to create “safe” assets – that is to increase the size of the collateral base to accommodate the money supply.
Why not call on the banks to create safe assets by underwriting loans carefully? Such loans after all have historically been all that is necessary to back the money supply. Perhaps the answer to the question is that “safe” privately issued loans aren’t part of the economic model being used? I sometimes feel that macroeconomic models that treat government as the social planner’s deus ex machina have so infiltrated some economists’ thought processes that they actually expect a real world government to successfully play the role of a benevolent deity.
If the financial system is so fundamentally unsound that the banks should not be extending unsecured interbank credit each other, the government is not going to be able to do anything to save it.