Six years ago, the failure of two hedge funds at Bear Stearns sent a small ripple through the commercial paper market. What started out looking like a temporary blip in the economic freight train ended with the failure of large swaths of the banking system, the biggest recession in 70 years, and an unprecedented policy response that continues to this day. Though the crisis had many causes – over-leverage at banks and investment banks, lax lending standards and an opaque derivatives market to name a few – it was a blowup in the commercial paper market that became the proverbial canary in the mine.

I thought about the crisis and response as I read today’s history lesson from Bloomberg about Paul M. Warburg, the “father of the discount window” (“Bernanke’s Recession-Fighting Weapon Developed by 1900s Banker”). Warburg understood that banking paper and money markets are a great way to wring inefficiencies out of the banking system and be a “win-win” for banks and bank customers in terms of matching short-term borrowing and lending needs. However, Warburg also understood that, during times of market stress, a backstop was needed, lest all participants race for the exits at the same time and create panic.

The problem is, of course, the market will eventually grow complacent with risk and become over-reliant on the backstop always being there. If and when too much risk builds in the system, conditions become ripe for a perfect storm that can pull the backstop out of its footings. In other words (those of economist Hyman P. Minsky), “stability breeds instability.”

Warburg’s legacy is alive and well in today’s Federal Reserve. The policies of ultra-low interest rates and quantitative easing pulled the banking system back from the brink. However, the policies have amounted to simply reinforcing the backstop and, at the same time, reinforcing the risks that require a larger and sturdier backstop. Eventually, this backstop will be tested.

The new canary in the mine may very well turn out to be China, where the paper market looks to be blowing up in much the same way the U.S. markets panicked in 2007-08. A similar mini-panic this past summer prompted a swift and severe response by the People’s Bank of China. Today, again, China stepped in as money rates approached 10 percent. The market is clearly jittery and the central bank is buying time as it attempts to calm fears that its banking system is in trouble.

Warburg’s legacy is about to be tested again. Will it be enough? Is that a canary I hear singing, or is it gasping for breath?

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