Illiquidity is a short-term funding problem. Insolvency reflects deeper, long-term balance-sheet weaknesses that can be addressed only through new equity, mergers or orderly resolution. The central challenge for policymakers is to determine whether an institution is solvent but temporarily illiquid, or insolvent and therefore in need of restructuring. If regulators cannot reliably draw this distinction for banks, despite having granular supervisory data, they certainly cannot do so for non-banks, where transparency is far more limited.
The banking turmoil of 2023 underscored the risks created by this mission creep. My co-authors and I estimated that hundreds of banks faced large mark-to-market losses on long-duration assets, operated with thin capital buffers, and relied heavily on uninsured deposits. Yet instead of calling for recapitalisation or restructuring, the episode was widely framed as a liquidity crisis. New facilities effectively extended support to roughly US$9 trillion in uninsured deposits, vastly expanding the financial safety net.
By acting as a lender of immediate resort, the Fed may have stabilised markets in the short run. But it also left underlying incentives unchanged, setting the stage for future crises and putting its independence under growing strain. Higher interest rates, though necessary to rein in inflation, exposed widespread interest-rate risk across the banking system. This left the Fed in a bind: raise rates aggressively and risk breaking the weakest banks, or hold back and allow inflation to persist. Financial fragility thus became an undeclared ceiling on monetary tightening.