Here\’s the set-up line for the story: Two central bankers walk into a London restaurant …

Mervyn King tells the tale at the start of his lecture \”Lessons from the Global Financial Crisis,\” in a speech given upon receipt of the Paul A. Volcker Lifetime Achievement Award from the National Association for Business Economics (February 27, 2018). I\’m quoting from the prepared text for the talk. Of course, King was Governor of the Bank of England from 2003-2013, while Paul Volcker was Chair of the Federal Reserve from 1979-1987. This is how King tells the story of their first meeting back in 1991:

\”I first met Paul in 1991 just after I joined the Bank of England. He came to London and asked Marjorie Deane of the Economist magazine to arrange a dinner with the new central banker. The story of that dinner has never been told in public before. We dined in what was then Princess Diana’s favourite restaurant, and at the end of the evening Paul attempted to pay the bill. Paul carried neither cash nor credit cards, but only a cheque book, and a dollar cheque at that. Unfortunately, the restaurant would not accept it. So I paid with a sterling credit card and Paul gave me a US dollar cheque. This suited us both because I had just opened an account at the Bank of England and been asked, rather sniffily, how I intended to open my account. What better response than to say that I would open the account by depositing a cheque from the recently retired Chairman of the Federal Reserve. I basked in this reflected glory for two weeks. Then I received a letter from the Chief Cashier’s office saying that most unfortunately the cheque had bounced. Consternation! It turned out that Paul had forgotten to date the cheque. What to do? Do you really write to a former Chairman pointing out that his cheque had bounced? Do you simply accept the financial loss? After some thought, I hit upon the perfect solution. I dated the cheque myself and returned it to the Bank of England. They accepted it without question. I am hopeful that the statute of limitations is well past. But the episode taught me a lifelong lesson: to be effective, regulation should focus on substance not form.\”

Maybe you need to be an economist to see the humor in the story. But consider:  One central bank chair trying to pay with US dollars in a London restaurant, and the other adding dates to someone else\’s check. It\’s a story that should vanquish any doubts about whether central bankers are fallible human beings.

The rest of the lecture has some good nuggets, tot. King points out that 10 years ago at this time in 2008, we were about two weeks before the failure of Bear Stearns. He says:

\”During the crisis we were vividly reminded of three old lessons. First, our system of banking is fragile, and reflects what I call financial alchemy. Banks that appear to be well-capitalised one day are not the next. Solvency is in the eye of the lender. Second, banks that borrow short and lend long are, as we saw in 2008, subject to runs that threaten the payments system and hence the wider economy. Third, regulatory reform is well-intentioned but has fallen into the trap of excessive detail. The complexity of the current regulation of financial services is damaging and unsustainable.\”

One of King\’s proposals is for that central banks should become what he calls the Pawnbroker for All Seasons. The idea is that rather than putting central banks in a position where, in an emergency, they face a choice between uncontrolled lending and letting the financial system melt down, we need a plan in advance. King suggests that banks work with a central bank to think about the value of the bank\’s collateral–say, the mortgages and other loans held by the bank. The bank and the central bank together would agree that if a bank finds itself caught in a financial crisis, it would give this collateral to the bank in exchange for a loan of a predetermined amount. King says:

\”My proposal replaces the traditional lender of last resort function, and the provision of deposit insurance, by making the central bank a Pawnbroker for all Seasons. … In normal times, each bank would decide how much of its assets it would preposition at the central bank allowing plenty of time for the collateral to be assessed. … Adding up over all assets that had been pre-positioned, it would then be clear how much central bank money the bank would be entitled to borrow – with no questions asked – at any instant. The pawnbroker rule would be that the credit line of the bank would have to be sufficient to cover all liabilities that could run within a pre-determined period of, say, one month or possibly longer. …The scheme is not a pipedream. US banks have pre-positioned collateral with the Federal Reserve sufficient to produce a total lendable value of just under one trillion dollars. Together with deposits at the Federal Reserve, the cash credit line of banks is around one-quarter of total bank deposits.\”

King\’s point is that a bunch of complex financial regulations–where their very complexity means they can be gamed–isn\’t a real answer. Solemnly swearing that the central bank won\’t lend in a crisis, and will just let the financial system melt down, isn\’t an answer, either. But thinking in advance about how much a central bank would lend to a bank, based on the collateral that bank has available, could actually help cushion the next (and there will be a next) financial crisis.

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