6 ideas
Banks take deposits redeemable on demand and use them to fund long-term, illiquid loans, which turns risky assets into supposedly safe money. The trick works only while depositors do not all ask for their money at once. Fragility is therefore built into the business model rather than being an occasional failure of management.
Each bank pre-positions collateral with the central bank, which sets a haircut on it in calm times. The bank must then hold liquid reserves plus the post-haircut value of that pledged collateral at least equal to its runnable short-term liabilities. In a crisis the central bank lends automatically against collateral already priced, so it no longer improvises lender-of-last-resort decisions under panic, and the implicit subsidy for liquidity risk is charged upfront.
Many economic futures cannot be assigned meaningful probabilities, because the relevant possibilities cannot even be listed in advance. Under such uncertainty, people act on narratives and rules of thumb rather than optimizing. Models built on known probability distributions therefore misdescribe how crises happen.
Promising unconditional rescue in a panic encourages banks to hold too little liquidity and to transform maturities more aggressively in normal times. Emergency lending that is cheap and discretionary therefore enlarges the very crises it is meant to stop. The central bank should price and precommit its insurance in advance rather than grant it ad hoc.
In 2007 Northern Rock relied on short-term wholesale funding to finance mortgages. When those markets froze it needed Bank of England support, and news of the support triggered queues of depositors — the first British bank run in over a century.
Recessions and financial crises are better seen as periods when spending and saving rest on shared expectations that later prove wrong. They are not shocks hitting an otherwise stable equilibrium. Pre-crisis borrowing and asset prices reflected a collective narrative about future incomes, and adjusting when that narrative breaks is slow and cannot be fixed by monetary stimulus alone.