Averting or creating banking crises? The lender of last resort and bank rescues

Abstract

Any propping up of shaky positions postpones liquidation and aggravates unsound conditions. Murray Rothbard In ordinary times the Bank [of England] is only one of many lenders, whereas in a panic it is the sole lender… Walter Bagehot The Bank of England financed merely the crisis: the private bankers of London and the provinces financed the boom. Arthur D. Gayer, W. W. Rostow and Anna Jacobson Schwartz Thus far in this book, we discovered that the UK banking system experienced two major crises: one in 1825–6 and the other in 2007–8. We also discovered that the stability of the system for a significant part of the interim period (at least until the 1920s and possibly beyond) is closely connected to the incentives provided first by unlimited liability and then by reserve liability and uncalled capital. The aim of this chapter is to understand how the Bank of England and the Treasury may have contributed (or otherwise) to the stability of the UK banking system in the past two centuries. In particular, the chapter analyses the evolution of the Bank’s (and the Treasury’s) fire-fighting role during crises. The chapter argues that the Bank’s role as a classical lender of last resort (LLR) was key to ending stress in the banking system during episodic pressure in the money market. However, the evolution of its role as a bailout coordinator or facilitator, backed by the Treasury, ultimately undermined the stability of the banking system. Bagehot and Thornton on the theory of the lender of last resort According to Kindleberger, the LLR ‘stands ready to halt a run out of real and illiquid financial assets into money by making more money available’. However, when we ask more questions, the LLR becomes a complex notion that means different things to different economists and that has changed over time. For example, who should be the LLR? How much should be loaned and on what terms? Should its availability be unambiguously signalled ex-ante? Should last-resort loans be made to the market or to individual institutions? If last-resort loans are to be made to individual institutions, should it be only to illiquid institutions or also to insolvent institutions? Can last-resort lending be structured so as to prevent moral hazard?