Lender of last resort
Lombard Street is known for its analysis of the Bank of England's response to the Overend-Gurney crisis. Bagehot's advice (sometimes referred to as "Bagehot's dictum") for the lender of last resort during a credit crunch is summarized by Charles Goodhart [5] as follows:
- Lend freely.
- At a high rate of interest.
- On good banking securities.
(Nonetheless, Goodhart emphasizes that many of these ideas were spelled out earlier by Henry Thornton's book The Paper Credit of Great Britain .)
Bagehot's dictum has been summarized by Paul Tucker [6] as follows:
- "to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates’".
High rates that cause losses to the firm may be too high, say higher than the interest rate the firm or bank is earning from the same asset it is placing as good collateral. Therefore, the highest interest to charge a bank for its good collateral without causing losses to it would be the same prevailing interest rate for said instrument or loan. In 1870 Britain the interest rate paid by the British Government for its annuities was 3.00% therefore a rate of 3.50% would have caused a loss of capital for a bank pledging this instrument as collateral. [7] We also have to consider that a bank has assets higher than its capital so any loss would cause a higher loss of equity for the bank, and it is not in the best interest of the central bank to cause high losses of equity to the firms making up its banking system. Therefore, if the asset has an interest rate of 3.00% a high central bank rate would be 2.50% without causing a leveraged loss of capital to the bank. Take for example the Bank of England's bank rate of 0.10% and the United Kingdom's 10 year Gilt at 0.65% on 14 July 2021. [8]
In Bagehot's own words (Lombard Street, Chapter 7, paragraphs 57–58), lending by the central bank in order to stop a banking panic should follow two rules:
- First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.
- Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer... No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business... The great majority, the majority to be protected, are the 'sound' people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.
A central bank, reserve bank, national bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base. Many central banks also have supervisory or regulatory powers to ensure the stability of commercial banks in their jurisdiction, to prevent bank runs, and in some cases also to enforce policies on financial consumer protection and against bank fraud, money laundering, or terrorism financing. Central banks play a crucial role in macroeconomic forecasting, which is essential for guiding monetary policy decisions, especially during times of economic turbulence.
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
Walter Bagehot was an English journalist, businessman, and essayist, who wrote extensively about government, economics, literature and race. He is known for co-founding the National Review in 1855, and for his works The English Constitution and Lombard Street: A Description of the Money Market (1873).
The Panic of 1837 was a financial crisis in the United States that began a major depression which lasted until the mid-1840s. Profits, prices, and wages dropped, westward expansion was stalled, unemployment rose, and pessimism abounded.
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In public finance, a lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other facilities or such sources have been exhausted. It is, in effect, a government guarantee to provide liquidity to financial institutions. 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.
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.
Lombard credit is the granting of credit to banks against pledged items, mostly in the form of securities or life insurance policies. The pledged items must be readily marketable; in particular, the securities 'eligible for collateral' which are registered on lists. Lending is via central banks. In the US, the Lombard rate was set at the top of the Federal Open Market Committee target range for the federal funds rate on March 16, 2020.
Lombard banking refers to the business of Italian moneylenders generally referred to as "Lombards", even though many originated from Northern and Central Italian regions other than Lombardy. The term was often used in a derogatory sense, as Lombard banking was associated with the sin of usury.
A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.
Overend, Gurney & Company was a London wholesale discount bank, known as "the bankers' bank", which collapsed in 1866 owing about £11 million, equivalent to £1,287 million in 2023. The collapse of the institution triggered a banking panic.
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United Kingdom banking law refers to banking law in the United Kingdom, to control the activities of banks.
Lombard Street is a street notable for its connections with the City of London's merchant, banking and insurance industries, stretching back to medieval times.
Kjell G. Nyborg is a financial economist. Since 2009, he has been a Chaired Professor of Finance at the University of Zurich, Department of Banking and Finance, where he is currently also Vice Director. In addition, he is a Senior Chair of the Swiss Finance Institute (SFI), a Research Fellow of the Centre for Economic Policy Research (CEPR), and a Fellow of the Royal Society of Arts. Nyborg is the President of the European Finance Association for 2017 as well as a former Director and Vice President. He has worked on a broad range of topics. The focus in his more recent work is on the role of money, liquidity, and collateral in Financial markets. He has also written extensively on financial auctions and Corporate Finance. His book Collateral Frameworks: The Open Secret of Central Banks on Cambridge University Press (2017) lays bare the "hidden" workings and practices of central banks. In the book he argues that more focus should be placed on central bank collateral policy as an important and integral component of monetary policy.
