Comment on: “Predatory trading, stigma, and the Fed׳s term auction facility” by Jennifer La׳o

Abstract

The Federal Reserve and other financial regulators often express concern about stigma associated with extending credit to distressed financial institutions (see, for example, Armantier et al., 2011). This concern seems perhaps odd as “stigma” maps more or less to information, and it is not clear why the Federal Reserve should withhold from the market legitimate information about the condition of certain institutions. Market participants should be able to use such stigma to refine their beliefs about which financial institutions are solvent and which are not. This paper provides a rationale for the Fed to view stigma as a problem and then presents a justification for the Term Auction Facility (TAF) program based on this concern. Briefly, the stigma associated with seeking liquidity in this model is bad because a strategic investor may learn about the liquidity position of a distressed institution and may attack that institution. The resulting liquidation is inefficient. The motivation for the model comes from Brunnermeier and Pedersen (2005), in which irrational traders sell, instead of buy, when a predator's action pushes prices below fundamentals. Predatory trading is not actually modeled in the paper, but it motivates the claim that a strategic actor can attack a solvent