Lender of last resort

Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general.

[1] While the concept itself had been used previously, the term "lender of last resort" was supposedly first used in its current context by Sir Francis Baring, in his Observations on the Establishment of the Bank of England, which was published in 1797.

[4] Although some of the details remain controversial, their general theory is still widely acknowledged in modern research and provides a suitable benchmark.

When there is a shock-induced panic, two things happen: Thornton first published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in 1802.

"[8] His main points can be summarized by his famous rule: lend "it most freely... to merchants, to minor bankers, to 'this and that man', whenever the security is good".

[10] Subsequently, the model has been extended to allow for financial contagion: the spreading of a panic from one bank to another, by Allen and Gale,[11] and Freixas et al.[12] respectively.

It is argued, for example, that the existence of a LOLR facility leads to excessive risk-taking by both bankers and investors, which would be dampened if illiquid banks were allowed to fail.

These countries then try to prevent moral hazard by other means such as suggested by Stern:[16] "official regulation; encouragement for private sector monitoring and self-regulation; and the imposition of costs on those who make mistakes, including enforcement of bankruptcy procedures when appropriate.

Rochet and Vives extend the traditional banking view to provide more evidence that interbank markets indeed do not function properly as Goodfriend and King had suggested.

"The main contribution of our paper so far has been to show the theoretical possibility of a solvent bank being illiquid, due to a coordination failure on the interbank market.

However, according to Goodhart, it is a myth that the central bank can evaluate that the suspicions are untrue under the usual constraints of time for arriving at a decision.

"[25] During the Panic of 1857, a policy committee of the New York Clearing House Association (NYCHA) allowed the issuance of the so-called clearing-house loan certificates.

While their legality was controversial at the time, the idea of providing additional liquidity eventually led to a public provision of this service that was to be performed by the central bank, founded in 1913.

However, historical experience (mainly Canada and US) suggested to him that it has to be a public authority and not a private clearing-house association that provides the service.

That allows him to reject the hypothesis that after the new Federal Reserve acted as lender of last resort, the frequency of panics observed did not change.

"[24] Bordo analyses historical data by Schwartz and Kindleberger to determine whether a lender of last resort can prevent or reduce the effect of a panic or crisis.

[28] The Bank of England is often considered the model lender of last resort because it acted according to the classical rules of Thornton and Bagehot.

[13] Norbert J. Michel, a financial researcher, goes as far as saying that the Federal Reserve made the Great Depression worse by failing to fulfil its role of lender of last resort,[33] a view shared amongst others by Milton Friedman.

[34] Critics like Michel nevertheless applaud the Fed's role as LLR in the crisis of 1987, and in that following 9/11,[35] (though concerns about moral hazard resulting were certainly expressed at the time).

[37] The classical economist Thomas M. Humphrey has identified several ways in which the modern Fed deviates from the traditional rules: (1) "Emphasis on Credit (Loans) as Opposed to Money", (2) "Taking Junk Collateral", (3) "Charging Subsidy Rates", (4) "Rescuing Insolvent Firms Too Big and Interconnected to Fail", (5) "Extension of Loan Repayment Deadlines", (6) "No Pre-announced Commitment".

[43] The European Central Bank arguably set itself up (controversially) as a conditional LOLR with its 2012 policy of Outright Monetary Transactions.

[44] In 1763, the king was the lender of last resort in Prussia; and in the 19th C., various official bodies, from the Prussian lottery to the Hamburg City Government, worked in consortia as LOLR.

Fischer says this role can and should be taken by the IMF even if it is not a central bank, since it has the ability to provide credit to the market irrespective of being unable to create new money in any "international currency".

[47] Fischer's central argument, that the ability to create money is not a necessary attribute of the lender of last resort, is highly controversial, and both Capie and Schwartz argue the opposite.

Besides this point (considered "semantic" by opposing authors), Capie and Schwartz provide arguments for why the IMF is not fit to be an international lender of last resort.

[50] Schwartz[51] explains that the lender of last resort is not the optimal solution to the crises of today, and the IMF cannot replace the necessary government agencies.

[51] Tooze has argued that, during and since the credit crunch, the dollar has extended its reach as a global reserve currency;[52] and suggests further that, at the height of the crisis, through the Central bank liquidity swap lines, the Fed "assured the key players in the global system...there was one actor in the system that would cover marginal imbalances with an unlimited supply of dollar liquidity.

[55] According to Paul De Grauwe,[55] the ECB should be the lender of last resort in the government bond market and supply liquidity to its member countries just as it does to the financial sector.

"The single most important argument for mandating the ECB to be a lender of last resort in the government bond markets is to prevent countries from being pushed into a bad equilibrium.

(2) All open market operations generate taxpayer risk, and if the lender of last resort is successful in preventing countries from moving into the bad equilibrium, it will not suffer any losses.