2.1The reserve that stands outside
Charles Kindleberger's Manias, Panics, and Crashes (1978) is a history of financial crises told as a recurring sequence: displacement, boom, euphoria, distress and panic. It is also a history of the lender of last resort (Kindleberger 1978). As this article reads the pairing, a history of that kind makes room for an actor whose position differs in kind from the positions that collapse: an institution that can act at the stage of panic because it is not caught in the sequence as the borrowers are.
Bagehot's rule, in the reading note's words, is that in a panic the holders of the final reserve should lend freely, at very high rates (Bagehot 1873). The rule presupposes a holder. It presupposes that the holder's reserve can be lent, which means it has not already vanished in the panic. And it presupposes that lending it will end the panic rather than spread it. On this side of the debate, the hard question is one of conduct: whether the holder will act, how fast, and at what price.
2.2The danger made inside
Hyman Minsky's Stabilizing an Unstable Economy (1986) states the financial instability hypothesis. In good times, finance moves from hedge to speculative to Ponzi positions, and stability breeds instability (Minsky 1986). This article needs only the direction of that movement, and reads the hypothesis as placing the source of fragility inside the system, in the period that looks calm, rather than in a shock from outside.
Richard Bookstaber's A Demon of Our Own Design (2007) makes a related claim about market structure. Markets are made complex and tightly coupled by their own innovations, and liquidity vanishes when it is most needed (Bookstaber 2007). The second half of that claim bears directly on collateral. Collateral is valued on the assumption that it can be sold, and a margin call is met on the assumption that something can be sold or borrowed against. If liquidity vanishes at the moment of need, both assumptions fail together.
Charles Perrow's Normal Accidents (1984) supplies the terms in which such claims are often put. Interactive complexity and tight coupling are two independent dimensions of a system; in systems high on both, accidents are normal, in the sense that they are to be expected from the structure and not from a single error (Perrow 1984). Perrow wrote about high-risk technologies, not about money markets. The reason to bring him in here is that the second side of the debate needs a way to say that a panic can come from the way parts are joined, not only from a shock or a mistake.
2.3The two sides set side by side
The table is this article's summary of the reading notes, not a claim the authors make in these words.
| Question | The reserve that stands outside | The danger made inside |
|---|---|---|
| Where does the panic come from? | A stage in a recurring sequence of displacement, boom, euphoria, distress and panic (Kindleberger) | Positions built in good times; stability breeding instability (Minsky); innovations that couple markets tightly (Bookstaber) |
| What answers it? | A lender of last resort (Kindleberger); holders of the final reserve lending freely at very high rates (Bagehot, as the note gives his rule) | Nothing in the notes names a remedy; liquidity vanishes when it is most needed (Bookstaber) |
| Does the buffer keep its value in the panic? | Assumed, for the final holder | Not assumed; the buffer's value depends on the same liquidity that vanishes |
| What kind of failure is it? | A crisis to be managed by a well-placed actor | A failure to be expected from the structure (Perrow) |
2.4The margin call between them
A private margin system sits between the two sides. It has a reserve in each account, the collateral posted, and a rule for when the reserve falls short, the call. But it has no holder of a final reserve. Each lender calls on its own borrowers, and each borrower must find collateral in the same market. When the second side's account holds, every lender calls at once.
Two further works in the parent study help name what is at stake in writing such a system down. Michael Power's Organized Uncertainty (2007) treats risk management as a way organisations turn uncertainty into objects they can manage and account for (Power 2007). A collateral schedule that counts units of a security, or a margin figure printed on a screen, is such an object. John Kay and Mervyn King's Radical Uncertainty (2020) holds that many decisions face uncertainty that probabilities cannot capture, and recommends strategies robust and resilient to what cannot be foreseen rather than optimisation on invented numbers (Kay and King 2020). Bagehot's twelfth chapter, read below, takes a position on the same question when it refuses to fix the reserve as a proportion of liabilities.