Financial dominance: why the ‘market maker of last resort’ is a bad idea and what to do about it

Abstract

Financial regulation, influenced by mainstream models of banks as sources of liquidity risk, rather than post-Keynesian models of banks as liquidity providers, fostered the growth of the repo market and shadow banking from the 1980s on. In the repo market banks provide funding liquidity, which interacts with market liquidity to cause liquidity spirals. Examples are the 2008 and 2020 crises. The central bank has responded to these crises by stepping in to purchase assets. This paper argues that we are now in a situation of ‘financial dominance’ where sophisticated financial market participants design financial instruments in expectation that the central bank will rescue the debt market from liquidity spirals. To address the problem of financial dominance, this paper argues for regulation based on the post-Keynesian approach to banks such that central bank financial support is provided via the banking system. This paper recommends (i) requiring that non-financial corporation repo and derivatives liabilities be supported by bank lines of credit and that banks face constraints on the ability to sell collateral into an illiquid market; (ii) requiring that monetary run-risk intermediaries, such as money market funds, be regulated as banks; and (iii) stricter regulation of BBB rated holdings for investment funds (or non-monetary run-risk intermediaries) when they are prohibited from holding below investment grade assets. These reforms must be accompanied by a clear policy that, in the event that any bank requires re-capitalization by the government, existing shareholder interests will be wiped out, and ownership will be transferred to the government.