Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….