There is a second reason that the hands-off approach has been shown to be wanting. During the past few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long and, as a result, have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no supervision, just as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.
Would you like to comment?
Join Diigo for a free account, or sign in if you are already a member.