AN INTERNATIONAL LLR: A BRIEF HISTORY OF A CONCEPT

The notion that the central bank ought to act as a nation’s lender of last resort has British roots. Unsurprisingly, it was an idea born out of crisis. During the nineteenth century and early twentieth century, financial crises were fairly common occurrences. Bank runs led to drains on central bank gold reserves, often prompting monetary authorities to contract credit. And although this response intuitively seemed the proper course of action, it invariably served to worsen the crisis.1 Sir Francis Baring is recognized as the originator of the term when he referred to the Bank of England as the dernier ressort from which all other banks could acquire liquidity during times of crisis.[1] [2] Henry Thornton built on Baring’s novel term, noting the central bank’s distinctive role as the ultimate source of liquidity during financial panics.[3] Walter Bagehot further refined Thornton’s ideas and is often cited as the father of the concept (even though his writing on the subject came decades after Thornton’s). Recognizing the self-fulfilling nature of financial crises, Bagehot argued that the central bank should do just the opposite. The only way to end such a mania is to immediately assure the public that there is no shortage of liquidity. Bagehot forcefully articulated his argument as follows: "Theory suggests, and experience proves, that in a panic the holders of the ultimate Bank reserve (whether one bank or many) should lend to all that bring good securities quickly, freely, and readily. By that policy they allay a panic; by every other policy they intensify it.”[4] In other words, when faced with panics, the monetary authority ought to provide unlimited and automatic credit to any party with good collateral.[5]

The lender of last resort was not simply doing the banks a favor, however. Thornton and Bagehot each recognized that allowing a solvent bank to collapse, perhaps because of a rumor or speculation about its health, was just as bad for the public as it was for the bank—especially since panics often quickly spread among institutions, threatening the stability of the broader, national financial system. As Thornton put it, the lender of last resort’s responsibility was not to any one bank but rather to “the general interests.”[6] The ideas of Thornton and Bagehot have changed little over the last two centuries as the need for central banks to perform the lender of last resort function for the national economy has not changed much over time. Indeed, the emergence of large commercial banks has, if anything, increased the need for central banks to act as guardians of the financial system as a whole.[7] However, neither scholar considered the need for or composition of an international lender of last resort. This was left to intellectuals of the late twentieth century.

  • [1] Goodhart and Illing 2002.
  • [2] Baring (1796) 1967.
  • [3] Thornton ([1802] 2008) cited two reasons for this. First, it possessed gold reserves fromwhich distressed institutions could draw from and, second, it could print its own paper currency, which was considered as good as gold. And while Thornton saw the primary role ofthe central bank as regulating the money supply at a noninflationary pace, he argued that, intimes of panic, the central bank should actually increase the money supply so as to provide astabilizing mechanism and meet public demands for paper.
  • [4] Bagehot 1873.
  • [5] However, he added that this lending should take place at a high rate of interest relative tothe precrisis period; Bagehot called this lending at a “penalty rate.” Any institution that wasunable to present good collateral was to be deemed insolvent and should be allowed to fail.
  • [6] Thornton (1802) 2008.
  • [7] Freixas et al. (2002) conclude that there are two fundamental justifications for whycentral banks should assume lender of last resort responsibilities. The first is the problemof information asymmetry, which leaves otherwise solvent banks exposed to deposit withdrawals and/or the seizing of interbank lending during a crisis, which can, in turn, causeinsolvency and a welfare loss for the bank’s stakeholders. The second justification, which ismore recent in its origins, is the “too big to fail” concept. If an otherwise solvent major bankfails (or a collection of smaller banks), the entire financial system may be unable to performits basic functions, including the “smooth operation of the payments system, and the intermediating between savers and borrowers with an efficient pricing of risk” (45). The lender oflast resort function is not without its detractors, however. The criticism most commonly levied at the concept is that it introduces moral hazard into a national financial system. Criticsargue that it makes risk-taking behavior on the part of financial institutions more likely,which increases the likelihood of future crises (Kaufman 2002).
 
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