Intervening 10 years ago to contain the damage from the banking system’s excessive risk-taking in mortgage-backed securities, the European Central Bank initiated what has proven to be an exceptional and prolonged involvement in markets by central banks. Much has changed since then, yet too much remains the same. The risk of unsettling financial instability, while lower, has morphed and migrated but has not disappeared.
On Aug. 9, 2007, an announcement by BNP Paribas brought to life investors’ worst fear: that, regardless of price, they would not be able to redeem any of their holdings in three investment funds. Underlying this dramatic announcement was excessive exposure to inherently illiquid securities by investment funds that overpromised investors access to their funds.
Realizing the threat to systemic financial stability, the ECB under the leadership of Jean-Claude Trichet did what central banks do best in these situation to avoid cascading market failures — it provided ample liquidity. But neither officials in Frankfurt nor at other major central banks, let alone at ministries of finance, realized that there was a much larger problem — that of excessive risk-taking by a banking system.continue reading »