While the Federal Reserve's lending programs have done much to prevent all-out collapse of the financial system, two economists are suggesting the Fed also might have kept alive weak banks and other institutions having balance sheets stuffed with toxic assets. Such institutions are dubbed "zombie," because without the support being offered by the Central bank they otherwise would have "died."
That's the theory in a research paper by Douglas Diamond and Raghuram Rajan of the University of Chicago, published online this week by the National Bureau of Economic Research.
The central bank's balance sheet has more than doubled since August 2007 as the Fed widened the available pool of credit instruments it would accept as collateral. For example, the Term Securities Lending Facility lets banks borrow money using mortgage-backed securities and other hard-to-sell assets.
But the Fed also might have kept alive weak banks and other institutions having balance sheets stuffed with toxic assets, the two professors suggest. The weak are afraid to sell such assets because doing so would wipe them out, while strong institutions don't want to buy because they are holding out for a fire sale.
Without a lifeline from the Fed, the weaklings could have died, putting the assets in stronger hands at cheaper prices.
"Central bank intervention to lend against all manner of collateral may not be an unmitigated blessing," Messrs. Diamond and Rajan wrote.
The consumer-loan-focused Term Asset-Backed Securities Loan Facility, which will roll out "very soon," Fed Chairman Ben Bernanke said Wednesday, could raise similar problems if consumer credit quality keeps withering.
Of course, doing nothing to help credit would have been catastrophic. But "zombie" banks are a reminder that clearing one logjam can make another one even worse.
Mervyn King, Bank of England governor, insisted on Thursday he would not allow ”a great inflationary surge”, as the monetary policy committee prepares to embark on the process of quantitative easing.
Mr King told Parliment that he expected to start pumping more money into the economy in ”the next few months” as the Bank starts buying up assets, thus boosting the money supply.
With interest rates at 1%, Mr King’s room for maneuver in traditional monetary policy terms is highly limited, but he insisted he was determined to keep inflation in check.
”We are not going to allow a great inflationary surge,” he told the Commons Treasury select committee. ”The problem at present is not that the amount of money in the economy is growing too rapidly, threatening an inflationary surge, it’s that the amount of money in the economy is growing too slowly.
He added: ”That is why we’ve asked the chancellor for powers to engage in asset purchases in order to increase the amount of money in the economy and I would expect that to happen over the next few months.”