Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a "tax on alchemy". They would be set at tough levels and could not be altered in a crisis. The central bank would have become a "pawnbroker for all seasons".

The value of liquid assets would then be known. They would consist of re­serves at the central bank plus the ag­reed collateral value of any other assets. In the long run, argues Lord King, liquid assets, so defined, should match an institution's liquid liabilities, defined as loans of a year's maturity or less.

This scheme has several advantages. First, it recognises that only the central bank can create needed liquidity in a crisis. Second, it offers a path to a world without alchemy. Third, it offers an option between the status quo and the extreme of 100 per cent reserve banking. Fourth, it eliminates moral hazard, since the penalty on obtaining liquidity would be defined in advance. Fifth, it exploits today's circumstances, including the reserves created by quantitative easing and the infrastructure created by central banks to assess and manage collateral. Sixth, regulation could then be reduced to just two rules: a higher maximum leverage ratio (of at most 10 to one) and the rule that the pledgeable value of assets at the central bank must exceed the value of liquid liabilities.

Sounds great but would central banks really have the discipline to impose haircuts in a time of crisis (and would governments have the discipline not to come in with TARPs, GSE bailouts and the like, etc.)? The central banking prime directive of "lend unlimitedly in crisis but at punitive rates" is quite easy to say, but no one seems to have ever followed it (it's hard to, given the general environment of regulatory capture) ...

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