Lender of last resort

Although Alexander Hamilton, in 1792, was the first policymaker to explain and implement a lender of last resort policy, the classical theory of the lender of last resort was mostly developed by two Englishmen in the 19th century: Henry Thornton and Walter Bagehot. In his book Lombard Street (1873), he mostly agreed with Thornton without ever mentioning him but also develops some new points and emphases. Bagehot advocates: "Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." 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". Summary of the classical theory Thomas M. Humphrey, who has done extensive research on Thornton's and Bagehot's works, summarizes their main proposals as follows: (1) protect the money supply instead of saving individual institutions; (2) rescue solvent institutions only; (3) let insolvent institutions default; (4) charge penalty rates; (5) require good collateral; and (6) announce the conditions before a crisis so that the market knows exactly what to expect. Many of the points remain controversial today but it seems to be accepted that the Bank of England strictly followed these rules during the last third of the 19th century. ==Bank runs and contagion==

Most industrialized countries have had a lender of last resort for many years. Models explaining why propose that a bank run or bank panic can arise in any fractional reserve banking system and that the lender of last resort function is a way of preventing panics from happening. The Diamond and Dybvig model of bank runs has two Nash equilibria: one in which welfare is optimal and one where there is a bank run. The bank run equilibrium is an infamously self-fulfilling prophecy: if individuals expect a run to happen, it is rational for them to withdraw their deposits early: before they actually need it. That makes them lose some interest, but that is better than losing everything from a bank run. In the Diamond–Dybvig model, introducing a lender of last resort can prevent bank runs from happening so that only the optimal equilibrium remains. That is because individuals are no longer afraid of a liquidity shortage and so have no incentive to withdraw early. The lender of last resort will never come into action because the mere promise is enough to provide the confidence necessary to prevent a panic. 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, and Freixas et al.{{Cite journal Allen and Gale introduced an interbank market into the Diamond–Dybvig model to study contagion of bank panics from one region to another. An interbank market is created by banks because it insures them against a lack of liquidity at certain banks as long as the overall amount of liquidity is sufficient. Liquidity is allocated by the interbank market so that banks that have excess liquidity can provide this to banks that lack liquidity. As long as the total demand for liquidity does not exceed the supply, the interbank market will allocate liquidity efficiently and banks will be better off. However, if demand exceeds supply, it can have disastrous consequences. The interregional cross-holdings of deposits cannot increase the total amount of liquidity. Thus, long-term assets have to be liquidated, which causes loss. The degree of contagion depends on the interconnectedness of the banks in different regions. In an incomplete market (banks do not exchange deposits with all other banks), a high degree of interconnectedness causes contagion. Contagion is not caused if the market is either complete (banks have exchanged deposits with all other banks) or if the banks are little-connected. In Allen and Gale's model, the role of the central bank is to complete the markets to prevent contagion. Freixas et al.'s model is similar to the one by Allen and Gale, except that in Freixas et al.'s model, individuals face uncertainty about where they will need their money. There is a fraction of individuals (travelers) who need their money in a region other than home. Without a payment system, an individual has to withdraw his deposit early (when he finds out that he will need the money in a different place in the next period) and simply take the money along. That is inefficient because of the foregone interest payment. Banks therefore establish credit lines to allow individuals to withdraw their deposits in different regions. In the good equilibrium, welfare is increased just as in the Diamond–Dybvig model, but again there is a bank run equilibrium, too. It can arise if some individuals expect too many others to want to withdraw money in the same region in the next period. It is then rational to withdraw money early instead of not receiving any in the next period. It can happen even if all banks are solvent. ==Disputed matters==

There is no universal agreement on whether a nation's central bank or any agent of private banking interests should be its lender of last resort. Nor is there on the pros and cons of actions such a lender takes and their consequences. Moral hazard Moral hazard has been an explicit concern in the context of the lender of last resort since the days of Thornton. 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. Therefore, the LOLR can alleviate current panics in exchange for increasing the likelihood of future panics by risk-taking induced by moral hazard. Some authors also suggest that moral hazard should not be a concern of the lender of last resort. The task of preventing it should be given to a supervisor or regulator that limits the amount of risk that can be taken. suggests that the private market for interbank loans can fail if banks face uncertainty about the risk involved in lending to other banks. In times of crisis with less certainty, however, discount window loans are the least costly way of solving the problem of uncertainty. 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." Goodhart and the Suffolk Bank of Boston Some authors view the establishment of clearing-houses as proof that the lender of last resort does not have to be provided by the central bank. Bordo agrees that it does not have to be a central bank. 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.{{Cite journal ==Historical experience==

Miron, and Goodhart More recent examples are the crises in Argentina, Mexico and Southeastern Asia. There, central banks could not provide liquidity because banks had been borrowing in foreign currencies, which the central bank was unable to provide. a view shared amongst others by Milton Friedman. Critics like Michel nevertheless applaud the Fed's role as LLR in the crisis of 1987, and in that following 9/11, (though concerns about moral hazard resulting were certainly expressed at the time). However, the Fed's role during the 2008 financial crisis continues to polarise opinion. 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". Indeed, some say its lender of last resort policies have jeopardized its operational independence, and have put taxpayers at risk. Mervyn King however has pointed out that 21st century banking (and hence the Fed as well) operate in a very different world from that of Bagehot, creating new problems for the LLR role Bagehot envisaged, highlighting especially the danger that haircuts on collateral, punitive rates, and the stigma of the deposit window can precipitate a bank run, or exacerbate a credit crunch: "In extreme cases, the LOLR is the Judas kiss for banks forced to turn to the central bank for support". As a result, other strategies were called for, and were indeed pursued by the Fed. The historian Adam Tooze has stressed how the Fed's new liquidity facilities mapped onto the various elements of the eviscerated shadow banking system, thereby replacing a systemic failure of credit as LLR, (a role morphing perhaps into that of a dealer of last resort). Tooze concluded that "In its own terms, as a capitalist stabilization effort...the Fed was remarkably successful". ECB The European Central Bank arguably set itself up (controversially) as a conditional LOLR with its 2012 policy of Outright Monetary Transactions. Prussia/Imperial Germany 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. After unification, the financial crisis of 1873 forced the formation of the German Reichsbank (1876) to fulfil that role. ==International lender of last resort==

Theory The matter of whether there is a need for an international lender of last resort is more controversial than for a domestic lender of last resort. Most authors agree that there is a need for a national lender of last resort and argue only about the specific set-up. There is, however, no agreement on the international level. There are mainly two opposing groups: one (Capie and Schwartz) says that an international lender of last resort (ILOLR) is technically impossible, while the other (Fischer, Obstfeld, 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. "A lender-of-last-resort is what it is by virtue of the fact that it alone provides the ultimate means of payment. There is no international money and so there can be no international lender-of-last-resort." 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. That precisely was the role of the global lender of last resort". Concern as to whether the Fed is in a position to repeat its role as global LOLR is one of the forces behind calls for a formal global currency. ==In government bond markets==

Although the European Central Bank (ECB) has supplied large amounts of liquidity through both open market operations and lending to individual banks in 2008, it was hesitant to supply liquidity during the sovereign crisis of 2010.{{Cite book Arguments put forth against a lender of last resort in the government bond market are the following: (1) inflation risk from an increase in the money supply; (2) losses to taxpayers because in the end they bear the losses of the ECB; (3) moral hazard: governments have an incentive to take more risk; (4) Bagehot's rule of not lending to insolvent institutions; and (5) violation of the statutes of the ECB, which do not allow the ECB to buy government bonds directly.{{Cite journal According to De Grauwe, none of the arguments is valid for the following reason: (1) The money supply does not necessarily increase if the money base is increased. (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. (3) The risk of moral hazard is identical to the moral hazard in the financial market and should be overcome by risk-limiting regulation. (4) If the distinction between illiquid and insolvent were possible, the market would not need the support of the lender of last resort, but in practice, the distinction cannot be made. (5) While Article 21 of the treaty prohibits buying debt from national governments directly because it "implies a monetary financing of the government budget deficit", Article 18 allows the ECB to buy and sell "marketable instruments", and government bonds are marketable instruments. Finally, De Grauwe asserts that only the central bank itself has the necessary credibility to act as a lender of last resort and so it should replace the European Financial Stability Facility (and its successor, the European Stability Mechanism). The two institutions cannot guarantee that they will always possess enough liquidity or "fire power" to buy debt from sovereign bond holders. ==See also==