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1
Central Banks and Financial Stability: Rediscovering the
lender-of-last-resort practice in a finance economy
Laurent Le Maux
*
and Laurence Scialom
**
June 2012
The purpose of our paper is to assess whether central banks have adopted new practices
of lending in last resort during the 2007-2009 financial crisis. We compare the current
period with the classical period, both featured by a finance economy with developed
financial markets and unregulated institutions. Beyond the differences determined by the
monetary regime regarding the central bank rate policy, we find similarities such as the
enlargements of the set of counterparts and eligible collaterals. Since the credit system is
based on financial markets and innovations, central banks then have a wider involvement
that goes beyond a narrow interpretation of the lender of last resort that prevailed under
the post-World War II regulated banking system. We conclude that the historical roots of
central banking as lender of last resort, as well as market maker of last resort, have just
been rediscovered and should be analytically integrated in a finance economy.
Key words: Central bank, financial crisis, banking history
JEL classifications: E58, G01, G18
1. Introduction
The financial turmoil of 2007-2009 combined shortages in market liquidity and funding
liquidity with self-reinforcing dynamics. Market liquidity fell considerably for a wide
range of assets and became extremely thin for structured credit products. Such market-
wide events in the financial system are perceived simultaneously by all market
participants, whose reactions are synchronized and fuel the price decline as well as the
reappraisal of risks. Furthermore, the adoption of fair value accounting rules immediately
validates market prices in the balance sheet of financial institutions. Therefore, changes in
asset prices impair the net worth of all the participants and undermine funding liquidity.
A tightening in market liquidity rapidly translates into changes in the equity base of banks
and other market intermediaries (nonbanks or shadow banks). Since liquidity of financial
institutions interacts with their solvency, the frontier between illiquidity and insolvency
becomes blurred. In such a context, central banks acted in 2007-2009 as lender of last
*
University of Paris Saint-Denis (LED), laurent.le_maux@u-paris10.fr
**
University of Paris West Nanterre (EconomiX), laurence.scialom@u-paris10.fr
2
resort (LLR) and adapted their tools and practices in accordance with the specific nature
and depth of the financial disruptions. They created new facilities that covered a broad
spectrum of instruments for supplying liquidity to different financial institutions.
1
Consequently, they have been regarded as providing liquidity to the market in a
“nonstandard way” (Chailloux, Gray and McCaughrin, 2008, p. 5). Our purpose is then to
know whether central banks have adopted novel and exceptional procedures with regard
to LLR practices.
For this purpose, we compare emergency measures taken by central banks in 2007-
2009 with those applied during financial crises throughout the classical specie regime
(1821-1914). The classical period constitutes a reference for at least three reasons. Firstly,
Thornton (1802), Tooke (1848) and Bagehot (1873) devised the “classical” theory of
lender of last resort and studied the innovative actions of the Bank of England.
2
Secondly,
the financial environment presented similarities with the contemporary one insofar as the
credit system was based on securities markets, which were, for the most part, developed
and even globalized with a very low rate of inflation.
3
Moreover, large amounts of
commercial paper circulated among nonbank financial institutions such as bill brokers
and discount houses. Bagehot (1873, p. 196) described how “in Lombard Street, the
principal depositors of the bill brokers are the bankers […]. Such deposits are, in fact, a
portion of the reserve of these bankers; they make an essential part of the sums which
they have provided and laid by against a panic”. Similarly, unregulated financial
institutions such as hedge funds, market mutual funds or investment banks play a major
role nowadays in the financial system as well as in the crisis propagation process. In the
present paper, all the features of the classical as well as the current periods – low rate of
inflation, significant development of financial markets, credit system based on security
markets, and unregulated intermediation – will be referred to as a finance economy.
Thirdly, the banking crises and the central bank interventions during the classical period
were sometimes as impressive as was the case during the current period, from the crash of
1987 until the collapse of 2008-2009. By contrast, from the 1930s in United States and
the Second World War in Western Europe to the 1980s, even if financial liberalization
began in the late 1960s in the United States, the banking system can be considered as
highly regulated, and financial disorders and lending of last resort were not so frequent
and significant. In their study of the severe banking crises, Reinhart and Rogoff (2009)
show that most of them have taken place since the 1980s in developed countries and since
the 1990s in emerging ones. They state that the relative calm from the late 1940s to the
early 1970s “may be partly explained by booming world growth but perhaps more so by
the repression of the domestic financial markets (in varying degrees) and the heavy-
handed use of capital control.” (idid, p. 205).
With reference to the classical period, we shall mention the Bank of England and the
US Clearing Houses. Unlike most European nations, the United States had no official
central bank during the nineteenth century. After the severe crisis of 1907, the U.S.
Congress produced a political compromise – the Federal Reserve Act of 1913 – that
1
On the 2007-2009 crisis, see, among others, Leijonhufvud (2007), Bank for International
Settlements (2009), Brunnermeier (2009), Adrian and Shin (2010), Cecchetti (2009), Cecchetti
and Disyatat (2010), Gorton (2010), Mishkin (2011); on and the emergency measures, see Aglietta
and Scialom (2009), Cecchetti (2009), Freixas (2009), Mehrling (2010), Goodfriend (2011).
2
Humphrey and Keleher (1984), Goodhart (1988, 1999), Humphrey (1989), Laidler (2003)
examine the lender of last resort in theory and in history.
3
On financial integration and effect of capital mobility on banking crisis, see Eichengreen
(1996), Bordo, Eichengreen and Kim (1998) and Bordo, Eichengreen and Irving (1999), Kaminsky
and Reinhart (1999), Obstfeld and Taylor (2004).
3
settled the long-standing conflict between supporters and opponents of central bank
(Timberlake, 1993). Under the National Banking System that prevailed before the Federal
Reserve, central bank functions were fragmented and carried out by different institutions.
Among them, the National City banks, especially those from New York, centralized part
of the money reserves; the Treasury attempted to smooth interest rates, especially when
Leslie Shaw was Treasury Secretary; and the Clearing Houses intervened as lenders of
last resort. The New York Clearing House was probably the most sophisticated of the US
Clearing Houses during the National Banking era and acted as a quasi-central bank. It
organized multilateral offsets of bank notes and cheques issued by commercial banks,
controlled and monitored member banks, and issued loan certificates that banking
institutions used as interbank means of payment. The loan certificates were considered as
a high-powered medium and could be issued in large amounts during periods of liquidity
pressures.
4
In order to know whether the recent “nonstandard” central bank interventions
constitute a real change, we shall present a comparison with the classical period. The
main difference described in section 2 between the two periods is based on the monetary
regime - the specie standard in the classical period and the fiat money regime in the
current period - which entails a difference in the central bank rate policy and in the nature
of cooperation between central banks. However, both periods may similarly be
considered as financial economies, characterized by the extension of securities markets
and the active role of nonbank institutions. Thus, beyond the matter of the monetary
regime and the setting of central bank rate, we discern continuity in the practices of the
lender of last resort. In this respect, we examine in section 3 the importance of central
bank money injections in 2007-2009, as well as those made during the classical period. In
section 4, we analyses in both periods the enlargement of the set of counterparties, which
raises problems relating to stigma and banking supervision and, in section 5, we trace the
enlargement of eligible collateral, which is linked to the broadening of the category of
counterparties, as well as to financial innovations. Since the financial markets and
innovations are highly developed and once the range of counterparties and collaterals is
enlarged, central banks tend to intervene simultaneously as lenders and market makers of
last resort. The market maker of last resort with regard to the private sector assets is not
only a contemporary function of central banking, but it emerges in periods of finance
economy. In sections 6, we provide some empirical illustrations and analytical
implications. Finally, the centralized liquidity allocation we define in section 7 goes
beyond crisis management or liquidity injection and seems to have been a new practice
that central banks implemented in 2007-2009. The fact that central banks had recourse to
the centralization of liquidity allocation reveals the severity of the recent crisis, whereas
the injection of liquidity appeared to be sufficient to resolve financial crises in the past.
We conclude in section 8 that the historical roots of financial stabilization by central
banks in a finance economy, characterized by developed financial markets and
unregulated intermediation may be found in the classical period and have just been
rediscovered.
4
On the US Clearing Houses, see Whitney (1878), Cannon (1910), Sprague (1908, 1910) and
Gorton (1985). The Clearing House system cannot be likened to a complete central bank for at
least two reasons. On the one hand, the participation of banking institutions in regional Clearing
Houses was not legally compulsory. On the other hand, the clearing system was not federally
unified. Note that the lack of unification in the US banking system was not completely resolved at
the beginning of the Federal Reserve System and the membership is still not legally compulsory.
4
2. Interest rate policy and monetary regime
As a first response to financial and banking difficulties in 2007-2009, central banks in
many countries reduced their interest rates to very low levels. The Federal Reserve began
to ease monetary policy before the other central banks and reduced the target for the
federal funds rate since September 2007. Usually, interest rate policies are not
coordinated among central banks. However, the intensification of financial trouble after
the Lehman Brothers bankruptcy in September 2008 led to an unprecedented response,
and outstanding coordination took place on 8 October 2008, when six major central banks
simultaneously announced a policy of rate cuts. In 2009, the Federal Reserve, the Bank of
Japan and then the Bank of England had brought interest rates nearly to zero and the
European Central Bank to 1%. The goals of these sharp reductions in interest rates were
twofold. On the one hand, they contributed to containing contagion through a
reassessment of the net present value of investment projects and counteracted the
negative effects of the liquidity shortage on asset prices. On the other hand, they directly
reduced the cost to banks of obtaining liquidity from central banks and reduced a
potential source of bank losses.
The central bank rate cuts in 2007-2008 were made possible by the fiat monetary
regime with flexible exchange rates and cannot therefore be compared with the discount
rate policy of central banks under the classical specie regime. At best, during the classical
period, there was a lack of coordination among Banks of Issue in Europe, and each of
them could set their discount rate without taking the others into consideration. At worst,
there was rivalry among central banks that triggered extreme changes in their discount
rates, and during international crises central banks could competitively raise their interest
rates in order to limit external drains of precious metal. A paroxysm occurred during the
1857 crisis between the Bank of England and the Bank of France, when they respectively
raised their interest rate to 10% and 8%, and led a “bank war” across the Channel through
telegraph lines (Patterson, 1866; Plessis, 1985; Le Maux, 2012). The well-known
argument of the Bagehot (1873) recommendation for an active use of the discount rate is
directly linked to this historical context. It rests on the argument that a “very high” level
of interest rate was supposed to generate deflation and thus to restore the balance of trade
and import of precious metals.
The monetary regime governs the interest rate policy and also the nature of the
international lender of last resort. Under the classical metallic regime, the central banks
were constrained by convertibility into specie. International lending cooperation among
them could take place through transfers of bullion but remained exceptional during the
classical period (Viner, 1937; Flandreau, 1997). Under a fiat money regime, they can
mutually provide unlimited amount of reserves through swap line programmes and thus a
network of central banks can behave like an international lender of last resort.
5
From
September 2008, the Federal Reserve announced a significant expansion of reciprocal
currency arrangements with foreign central banks through the cross-border Term Auction
Facility, which enhanced overseas dollar funding (Goldberg, Kennedy and Liu, 2011).
The dollar swap arrangements allowed the Federal Reserve to supply dollars without
needing to take a look at the collateral policies of, say, the European Central Bank or the
National Bank of Switzerland. The swaps provided foreign banks access to dollar term
funding at US market-determined rates but using Europe-based collateral. The alleviation
5
The use of the term “international lender of last resort” to define mutual swap operations
could be controversial. Actually, there is no international currency used universally by central
banks, but a small number of national currencies are used mutually in an international context as
an exchange reserve.
5
of the dollar shortage of foreign banks helped the Federal Reserve to reinforce its control
over the rates paid for dollar funding in money markets and limited ‘fire sales’ of dollar-
denominated assets by foreign financial institutions.
The fiat money regime that prevails nowadays is far less constraining than the
classical specie regime and renders the policy of interest rate cuts possible. However,
beyond these differences and irrespective of the monetary regime, other practices of the
LLR can be similar in a finance economy.
3. Liquidity injection and change in asset composition of central bank balance sheets
In 2007-2009, central banks provided liquidity on interbank and other wholesale markets
in two successive ways. From the beginning of the crisis until the failure of Lehman
Brothers, central banks sustained liquidity through changes in the asset composition of
their balance sheets, while keeping the overall size nearly constant. As long as the
increase in a risky class of assets (private sector securities) was compensated by a
decrease in another class of assets (public sector bonds) held by the central banks, net
injections of central bank liquidity were minor. After the Lehman Brothers bankruptcy,
central banks dramatically raised the size of their balance sheet. Between September 2008
and January 2009, the size of the balance sheets of the European Central Bank, the
Federal Reserve and the Bank of England respectively grew by 45%, 150% and 155%
(Bank of England, 2009; European Central Bank, 2009). Such expansions indicate the
magnitude of the net liquidity injection as well as the extension of purchase of large range
of assets. The central banks’ operations crossed a new threshold that triggered a further
deterioration in the quality of the asset side their balance sheets.
During the nineteenth century, the expansion in the balance sheets of central banks
was not as spectacular as for some central banks in 2007-2009. Nevertheless, despite the
specie regime and its convertibility constraint, the Bank of England actively intervened in
favour of banks and financial institutions by issuing high-powered medium in significant
amounts. In 1825, Bank of England notes in circulation went up 47% from late November
to late December (Parliamentary Papers, 1832, appendix 13, p. 192). It may also be noted
that after the Bank of England’s intervention, the composition of the asset side
unquestionably became riskier. Between June 1824 and December 1825, the reserves of
the Bank of England fell from £12 million to £1 million, and the annual average amount
of commercial paper under discount rose from £2.4 million in 1824 to £4.9 million in
1825 (ibid, appendix 1, p. 169; appendix 19, p. 224). The Bank’s intervention in 1825
promptly stopped the panic during the days following the injection of liquidity (King,
1936; Neal, 1998). The same result occurred with the Bank’s intervention in 1847, 1857
and 1866 after the announcement of the suspension of the Act of 1844 by the
Government (Newmarch, 1866). In the late nineteenth century, the Bank’s liabilities in
the form of bankers’ balance gained in significance; during the 1878 crisis, for instance,
they increased by 40% in three months (Collins, 1992).
The classical period shows that a liquidity injection or even its mere announcement
could be sufficient to calm down financial distress, whereas the policies of the central
banks during the 2007-2009 crisis did not seem to achieve their objective. In any case,
injections of liquidity were massive and recurrent and, as we shall see, they were
associated with a widening of the range of counterparties and of eligible collateral.
6
4. Unregulated financial institutions and widening the category of counterparties
In their usual open market operations, central banks do not deal directly with all the
commercial banks and securities firms but only with a pre-specified category of
counterparties that redistribute the liquidity in the banking system. The different
components of the monetary operating frameworks may differ from country to country
(Borio and Nelson, 2008). For instance, in the European Central Bank system, the range
of eligible counterparties is wide and common across operations (open market operations
and standing facilities). In the United States, the counterparties for open market
operations (outright purchase and repurchase agreement) are significantly fewer than
those with access to standing facilities at the discount window (lending and deposit
facilities). Despite the fact that the relaxation of the eligibility of counterparties has been
greater in the banking systems that initially had a more restricted framework (in the
United States for instance), the central bank interventions during the recent crisis
presented similarities.
The need for adjustments of the central bank liquidity operations was justified by
banks’ reluctance to lend to each other in 2007-2009. It was reinforced by the US banks’
unwillingness to use standing facilities at the discount windows to avoid disclosing their
financial weakness. The usual purpose of standing facilities is to support settlement in the
payment system by providing collateralized overnight loans to direct participants in the
payment system who are experiencing temporary shortfalls in their settlement balances.
Banks pay an interest rate at the discount window higher than the target federal funds
rates, but the range of counterparties and eligible collaterals are wider for standing
facilities than for open market operations. The matter is that using the standing facilities
is perceived by banks as carrying a stigma, for it signalled their financial difficulties to
the other market participants. Since the transparent provision of liquidity is interpreted as
proof of vulnerability, it could lead interbank counterparties to react exactly in the
manner that the financial support is supposed to prevent. As a consequence, because there
was relatively little use of standing facilities, even on days when interbank market rates
rose above the standing facilities rates, the Federal Reserve created a new discount
window programme in December 2007, the Term Auction Facility (TAF). The TAF
concerned all of the 7000 commercial banks (and not only the primary dealers involved in
the open market procedure) and allowed any depository institution to place a bid for an
advance at an interest rate resulting from an auction. The accepted collateral (that is, any
collateral eligible to secure discount window loans) was much broader than with standard
repurchase agreements. Importantly, the TAF differed from the discount window insofar
as it guaranteed the bidders anonymity and thus avoided the stigma problem.
6
The Primary Dealers Credit Facility (PDCF), set up in March 2008 by the Federal
Reserve, has been another symptomatic step in the process of widening of the range of
counterparties. The primary dealers are not only banks but also investment banks and
brokers. The discount window borrowing and the TAF are both restricted to member and
regulated banks. Through the PDCF, investment banks and brokers could henceforth
6
The history of the US Clearing Houses gives an insight into the stigma problem. Clearing
Houses had strong incentives to monitor member banks and control them so as to evaluate the
quality of their portfolios in accordance with their capital (Cannon, 1910). The New York Clearing
House published information on the balance sheets of member banks as well as on their weekly
clearing balances. However, during crises, the New York Clearing House decided to suspend
publication of individual bank information in order to protect weaker banks against the stigma of
liquidity shortage (Gorton, 1985).
7
borrow from the Federal Reserve.
7
Like loans made to commercial banks at the discount
window, the PDCF allows borrowers to pledge from assets, including all investment-
grade corporate securities, municipal securities, mortgage-backed securities and asset-
backed securities. The privilege of access to emergency liquidity is normally reserved for
member banks of the Federal Reserve System, which bear regulation constraints limiting
their risk-taking. In extending the LLR umbrella to investment banks and brokers, which
were initially exempted from the banking regulation that is required for central bank
membership, the Federal Reserve crossed the Rubicon. This kind of regulatory arbitrage
and free riding is not without precedent, as the US trust company episode in 1907 reveals.
Trust companies emerged as financial intermediaries in the late nineteenth century in
the United States. They were specialized in collateralized loans, invested in the real estate
sector and chose aggressive strategies. In New York City, the assets of the trust
companies increased 2.5 times more than the assets of the national banks during the
decade preceding the 1907 crisis (Moen and Tallman, 1992). Under the National Banking
System, national banks were federally regulated while trust companies were far less
affected by state regulation. In particular, New York trust companies were less
constrained by their reserves than New York national banks, which had to meet a legal
reserve ratio equal to 25%. Before 1903, the New York Clearing House (NYCH)
accepted some trust companies as member banks, but in June 1904, it required a reserve
ratio between 10% and 15% so as to establish relative regulatory uniformity within its
system. The NYCH was not only worried about its own narrow interests but more
generally with the preservation of banking stability in New York City. However, trust
companies that were not Clearing House members refused to apply these new entry
requirements, and some member trust companies decided to leave the NYCH in order to
maintain their competitive advantage. Actually, the problem was not that the NYCH was
too negligent (Wicker, 2000) or, on the contrary, too stringent (Freixas and Parigi, 2008).
The real problem was the free riding behaviour of unregulated financial institutions. They
tried to preserve each opportunity for profit that the absence of legal requirement could
offer, to the detriment of the financial and banking system as a whole. During the panic of
October 1907, the NYCH did not straightforwardly sustain trust companies, but preferred
to grant loans to New York national banks, which then gave assistance to trust companies
they had close ties with and could get information about. Moen and Tallman (2000, pp.
147, 161) convincingly show that participation at the Clearing House was the key factor
for resolving the crisis: “The clearinghouse took action to protect the payments system,
but the clearinghouse’s method to contain panics relied on timely balance-sheet
information of member institutions; information from non-member trusts was perceived
as much less reliable. […] The New York trusts’ isolation from clearinghouse […] was
the key element in propagating the massive runs on deposits. […] These results indicate
that further studies highlighting the extent of clearinghouse or central-bank coverage
during crises will be useful in understanding the factors affecting the occurrence and
severity of bank runs.”
In Britain, eligible counterparties were not as codified during the nineteenth century as
today - for instance, several banks and financial institutions did not directly hold a current
account in the Bank of England - and they were more numerous than those institutions
with which the Bank had regular relationships. Large amounts were advanced to bill
7
Paragraph 3 of section 13 of the Federal Reserve Act allows lending to nonbanks under
“exigent and unusual circumstances” and thus could authorize the PDCF. On the PDCF, see
Adrian, Burke and McAndrews (2009). The Federal Reserve also lent to mutual funds through the
creation of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
(Adrian, Kimbrough, and Marchioni, 2011)
8
brokers and not only to banks. As an illustration, during the last three months of 1857, the
Bank of England advanced more than £9,500,000 to London bill brokers and discount
houses, whereas the advances to London and provincial bankers were £7,000,000, and
also £14,500,000 to London merchants and traders (Parliamentary Papers, 1858, appendix
13, p. 405). The Bank of England met with similar difficulties in its dealings with brokers
as the NYCH met with the trust companies, and hence the Bank announced a new rule in
1858 stipulating that the discount to the bill brokers was “closed altogether” (Neave,
Parliamentary Papers, 1858, qs. 688–695). As Woods (1939, p. 134) has interpreted it, the
objective of the rule was to threaten the brokers as far as possible, in order to force them
to maintain reserve balances at the Bank.
The broadening of the set of counterparties was mostly associated with an enlargement
of the set of collateral assets which were accepted as eligible for central bank facilities.
5. Financial innovation and enlarged eligible collateral
When central banks inject liquidity, they protect themselves against credit risk by
accepting collateral. The range of eligible assets is not harmonized across countries, and it
differs also in terms of qualifying assets across operations such as open market and
standing facilities. The credit facilities granted by central banks in 2007-2009 raised the
demand for liquid collateral assets (primarily government or government-guaranteed
assets) and so deprived banks of them for their regular funding operations in the interbank
markets. In order to overcome the impediments to a smooth distribution of liquidity, most
of the central banks therefore relaxed the requirements for eligible collateral. The Federal
Reserve and the Bank of England respectively created the Term Securities Lending
Facilities (TSLF) and the Special Liquidity Scheme (SLS) to purchase part of the
questionable assets by exchanging them temporarily with more easily tradable assets.
8
These measures aimed to lessen strains in wholesale interbank markets and to re-engage
the banking sector in the intermediation process, and they partly affected the market
pricing of specific assets. They entailed a shift in the asset composition of central banks’
balance sheets from liquid and safe assets towards illiquid and risky ones. This balance
sheet policy was transmitted through two main channels. First, the announcement that the
central bank was engaged in operations involving illiquid assets was designed to enhance
investor confidence and reduce liquidity premiums (signalling effect). Secondly, the
swaps of illiquid private assets for public sector bonds upgraded the overall risk profile of
bank balance sheets and were able to limit banks’ reluctance to lend to each other
(portfolio balance effect).
Strictly speaking, central banks did not broaden the range of eligible collateral in the
early nineteenth century, because they had not a priori defined a narrow set of securities
purchased in normal circumstances.
9
However, since the beginning of the history of
lending in last resort, the spectrum of assets eligible as collateral against advances and
8
The TSLF announced by the Federal Reserve on March 2008 was a lending programme that
provides Treasury securities against questionable collateral (such as mortgage-backed securities)
for 28 days while the traditional programme lends overnight (Fleming, Hrung and Keane, 2009).
On April 2008, the Bank of England announced the SLS, which was quite similar to the TSLF and
allowed banks and building societies to swap some of their illiquid private sector assets for
Treasury bills (Cross, Fisher and Weeken, 2010).
9
In the United States, according to the preamble of the Act of 1913, the Federal Reserve could
grant loans to member banks by rediscounting commercial paper and short-term negotiable
instruments issued as “real bills”, that is, for “agricultural, industrial, or commercial purposes”.
See Clouse and Small (2004).
9
securities purchased by central banks, like the category of counterparties, was quite
extensive. In this respect, the declarations of the directors of the Bank of England during
the 1832 Parliamentary Inquiry with regard to the assistance of the Bank of England
during the 1825 crisis are very suggestive. J. Harman (Parliamentary Papers, 1832, q.
2217), quoted by Tooke (1848) and Bagehot (1873), gave an instructive portrayal of the
lender of last resort: “we lent [our assistance] by every possible means, and in modes that
we never had adopted before; we took in stock as security; we purchased Exchequer bills;
we made advances on Exchequer bills; we not only discounted outright, but we made
advances on deposit of bills of exchange to an immense amount”; the Governor J. H.
Palmer (Parliamentary Papers, 1832, q.164) added that advances against title deeds had
also been considerable. Thus, as early as 1825, the Bank of England discounted outright
and made advances against collateral including commercial paper, bills of exchange,
stocks and Exchequer bills. Such practices continued throughout the nineteenth century.
For instance, the Governor J. Morris (Parliamentary Papers, 1848, House of Commons,
qs.2645–2648) explained that during the 1847 crisis, large amounts of aid was afforded
by the Bank in unusual ways, against real estate and debentures.
Financial innovations - such as securitization, nowadays - partly explained the
enlargement of the range of eligible collateral. As an example, during the 1860s, a new
financial instrument, widely used for financing the railways in Britain, consisted of a
contract by which the railway builder accepted shares or debts issued by the railway
companies in payment instead of cash. As a result, it boosted the intermediation activity
of new credit and financial institutions, which could purchase railway stocks and
securities from builders and negotiate them on markets. Newmarch (1866, pp. 230–1)
gave a description of “a system of extravagant agency and commission” which was
“pushed off with success in various avenues of the money-market”. At the same time, the
Companies Act of 1862 authorized firms in general and financial institutions in particular
to replace unlimited liability with limited liability and consequently created incentives to
increase their leverage. In September 1866, after the credit crisis in May and the ensuing
intervention of the Bank of England, some commentators worried about the fact that the
Bank was holding too many risky assets like railway securities (Bank of England, 1866).
However, Bagehot (1873, pp. 151–2) did not share this concern and believed that the
Bank could hold a large range of securities (commercial bills, public debts, India
securities, and railway debenture stocks) in a panic.
The broadening of collateral may also imply the lengthening of maturity for liquidity
provision. In 2007-2009, central banks faced a changing maturity composition in banks’
demand for funding liquidity, with an increase in the net demand for term funding
relative to overnight funding, in order to reduce their liquidity mismatch. Lending in
difficult circumstances for very short maturities entailed a rollover risk and remained
ineffective in periods of panic. To a varying degree all central banks increased the
availability of long-term funding supplied to the market through discretionary operations.
In comparison, the lengthening of maturity was not so frequent during the classical specie
regime, and central banks often reduced the maturity of the bills they discounted in order
to manage the level of their reserves. Nevertheless, when the Bank of England decided to
put an end to the panic in December 1825, the Court agreed to advance at 5% against
“long bills - beyond 95 days - which it did not usually discount” (Clapham, 1944, II, pp.
99–100).
All these central bank measures to ease the conditions for the provision of reserves by
enlarging the range of eligible collateral had been observed right throughout the episodes
of finance economy. They created the need for a wider interpretation of the lender of last
resort, to include the function of the market maker of last resort.
10
6. Insights into the market maker of last resort
In normal circumstances, the usual private market makers intermediate between end-
users of the financial system but, unlike general financial intermediaries, they do not act
as agents for end-users, but as principals. They provide continuous and effective two-way
prices under all market conditions and keep an orderly market by smoothing out price
fluctuations. When extended financial markets collapse, private market makers operating
in a short-term profit strategy might have neither the incentives nor the capital to carry on
their routine function of market stabilization. Furthermore, a financial stability policy
confined to granting credit facilities against good collateral is not enough to alleviate the
uncertainty regarding the average quality of assets. Central banks that are not constrained
by profit maximization may replace the usual market maker by absorbing and removing a
significant amount of dubious assets. This is the “market maker of last resort” function.
Buiter and Sibert (2007) who coined the phrase suggest that it can be fulfilled in two
ways: first, outright purchases and sales of a wide range of private sector securities;
second, acceptance of a wide range of private sector securities as collateral for repurchase
agreements and at the discount window. In the case of the Federal Reserve system in
2007-2009, Merhling (2010, pp. 106, 132) also explains the successive action of the
central bank – from the lender of last resort to the “dealer of last resort” role – as follows:
initially, “the Fed focused its intervention on funding liquidity, depending on the private
dealer system to translate that funding liquidity into market liquidity”; after the collapse
of Bear Stearns in March 2008, “the Fed began to pay more attention to the market
liquidity dimension directly” through the introduction of the TSLF. As the financial crisis
deepened after the Lehman Brothers failure in September 2008, the market-maker-of-last-
resort function was performed through outright purchases of private sector securities or
special lending facilities. The Federal Reserve intervened in the market of commercial
paper by lending directly to market participants, including ultimate borrowers and major
investors. The commercial paper market is a key source of short-term financing for US
corporate firms and, after September 2008, commercial paper rates spiked even for the
highest quality firms; most firms were unable to borrow for periods longer than a few
days. The Commercial Paper Funding Facility (CPFF) was specifically intended to
address rollover risk for commercial issuers and to improve the operations of the
commercial paper market (Adrian, Kinbrough and Marchioni, 2011). The Federal
Reserve also bought direct obligations from housing-related government sponsored
enterprises, as well as mortgage-backed securities backed by Fannie Mae and Freddie
Mac.
A line of thinking would claim that the recent financial experience would open up a
new era in which central banks should evolve from being the lender of last resort (LLR)
to the market maker of last resort (MMLR). However, from a theoretical point of view,
the issue is not to relinquish the LLR role in favour of the MMLR, but rather to consider
that central banks have to extend their LLR practices, since they are placed within a
finance economy, to the detriment of the narrow view prevailing in a regulated banking
system. The dynamic interdependence between market and funding liquidity prevailing in
a credit system based on securities markets implies that the LLR and MMLR functions
are intrinsically linked and should be analytically integrated. Moreover, from a historical
point of view, the previous section has shown that the broadened practice of the LLR may
be found in the classical period, since 1825 in England, and has merely been
rediscovered. Even if the concept of MMLR was not formulated, it was implicitly
discussed inside the institution. For instance, in September 1866, following the Bank of
England’s intervention in May, some of its shareholders doubted that its duty was to
support a segment of the money market by holding private railway company securities,
11
and they wanted to know “whether any of those debentures come from railway companies
that had since been able to meet their obligations” (Bank of England, 1866, p. 1106).
They worried that rumours outside the Bank stated confidently that large amounts of bills
had not yet been returned. The Governor answered with reassuring words that the Bank
held “no debentures except those of first class railway companies” (ibid.). The fact that
the MMLR concept was not shared or even formulated by central bankers during the
classical period should not disguise the fact that central banks were able to hold
questionable securities from markets in difficulty. Similarly, despite the fact that the Bank
of England was operating as a supplier of high-powered medium during periods of
pressure (Collins, 1992), the responsibility of LLR was far from being unanimously
accepted among the directors and a fortiori was not formally announced.
The rediscovery of the MMLR as a part of the LLR function may lead us to foresee
certain implications. Firstly, central banks might lose their position of neutrality with
respect to private agents. Once they temporarily intervene in the private sector securities
markets, and sustain prices of some categories of assets, they might influence the bid-ask
spread and relative prices and thus favour some borrowers over others. Secondly, in
acting as MMLR, central banks go beyond the strict application of the narrow view that
would advise lending against good collateral to illiquid but solvent banks. Once they have
been ready to purchase several kinds of private sector securities (which are not
necessarily “good”) from banks and also nonbank institutions (on which solvency
information is very limited), they suffer from a potential worsening of the quality of their
balance sheet. Finally, the enlargement of the LLR function threatens the smooth exit
from the crisis and the financial stabilization policy. In contrast to the self-liquidating
quality of assets acquired by the central bank in consequence of providing liquidity
facilities, the expansion stemming from purchases of risky assets does not necessarily
easily reverse itself when the financial system recovers. Risky assets accumulated during
the crisis may remain for some time in the central bank’s portfolio and may even trigger
an erosion of its capital.
7. The process of centralized allocation of liquidity
In the context of the beginnings of the finance economy in the 1980s, Goodfriend and
King (1988) assumed that interbank and financial market participants would be able to
distinguish between illiquid and insolvent institutions and that the market as a whole
could efficiently allocate liquidity between banks with a surplus and those with a deficit.
They claimed that “today’s financial markets provide a highly efficient means of
allocating credit privately” and found that “it is difficult to make a case for central bank
lending and the regulatory and supervision activities that support it” (ibid, p. 15; idem, p.
19). They concluded that monetary policy would be able to play an important role in a
banking crisis only by managing the volume of high-powered money, without costly
regulation and supervision from the central bank. However, the 2007-2008 disruption of
interbank lending reveals problems of decentralized allocation of liquidity, insofar as
amounts of idle liquidity could coexist with segments of liquidity shortage in interbank
markets – and not only because market liquidity shortage undermines funding liquidity.
Therefore, central banks had to go beyond the change in the volume of their balance
sheets: they reorganized interbank markets by centralizing the liquidity allocation from
banks with a surplus to those most in need.
What we mean by centralized allocation of liquidity is the twofold action of increasing
the quantity of provision for banks with a deficit and absorbing the excess liquidity of
banks with a surplus. Centralized allocation of liquidity is thus different from crisis
12
management. A crisis manager organizes the equalization of reserves from a pool of
banks with a surplus to those with a deficit (Fischer, 1999). The crisis manager can use
moral persuasion to induce cooperative behaviour, but the decision remains at the
discretion of banks with a surplus. The rescue of Long Term Capital Management
(LTCM) by a set of creditor banks in 1998 is a famous recent case of crisis management
by the Federal Reserve. In 2007-2009, central banks did not play a simple crisis manager
role. While they massively increased liquidity provision and enlarged the category of
eligible counterparties and collateral, they also absorbed excess liquidity by means of
various instruments such as deposit standing facilities, reverse repurchase agreements,
current accounts for reserve requirements and excess reserves. Between June 2007 and
September 2008, the size of the Federal Reserve’s balance sheet did not significantly
change, since the gross liquidity injection was compensated by the sales and redemptions
of Treasury securities. After the Lehman Brothers collapse, the Federal Reserve balance
sheet more than doubled and the depository institutions’ current account balances (which
cover minimum reserve requirements and excess reserves) increased from $20 billion in
January 2007 to $860 billion in December 2008. Reserve holding was mostly voluntary
and even encouraged when the Federal Reserve decided in October 2008 to pay interest
on excess reserve balances, which enabled banks to hold them without bearing
opportunity cost. The Federal Reserve thus borrowed from member banks with surplus
funds and stand between them and banks with shortage funds. Concerning the European
Central Bank, the main liquidity-absorbing instrument was the deposit facility which rose
from €1 billion at the end of June 2007 to over €300 billion at the end of 2008. The
important increase in liquidity provision on the asset side of the balance sheet, in addition
to the liquidity absorption on the liability side, indicates that central banks centralized the
liquidity allocation and thus partially replaced the money market.
In the classical period, central banks could occasionally intervene as crisis managers.
The action of the Bank of England during the Baring collapse in 1890 is commonly
mentioned. But as seen in the third section, the Bank acted most of the time as a LLR by
issuing high-powered medium during panics. In the United States, the evolution of the
way the Clearing Houses functioned is instructive. At its beginnings, during the 1860,
1861 and 1873 crises, the NYCH acted as a crisis manager and had to organize the
equalization of reserves through the transfer of reserves from banks with a surplus to
those with a deficit. Evidence clearly shows that the equalization of reserves took place at
the discretion of associated banks (Sprague, 1910, p. 94; Coe Report quoted in Wicker,
2000, p. 124). For this reason, it was a very uncertain method and it was progressively
replaced by the issuance of a high-powered medium, namely, the clearinghouse loan
certificates. To our knowledge, the injection of liquidity by the Bank of England or the
NYCH was generally sufficient to end liquidity pressure with no apparent need for the
centralized allocation of liquidity described above. This was no longer the case in 2007-
2009. The importance in kind and in degree of the centralized liquidity allocation
implemented by the Federal Reserve and the European Central Bank revealed the severity
of the freeze and disruption of the interbank markets.
8. Conclusion
Beyond the monetary regime, which determines differences regarding central bank rate
policy and the international lender-of-last-resort framework, we have discerned
similarities in the action of the central bank as lender of last resort, between the classical
period and the 2007-2009 crisis. They are both characterised by the development of
financial markets and unregulated intermediation. Central banks similarly issued large
13
important amounts of high-powered money and adjusted the level of information on weak
banks during the panic. However, they were often disturbed by the lack of information on
unregulated institutions. Finally, they enlarged the category of counterparties as well as
the spectrum of collateral. All of these features led central banks to act not only as a
lender but also as a market maker of last resort. This implies that the more the central
bank reinforces their involvement by purchasing dubious private sector assets, the more
difficult the crisis exit policy becomes. Finally, during the recent crisis, central banks
have had to go further than they did during the classical era, by absorbing excess liquidity
in addition to providing liquidity. This centralization of liquidity allocation seems to have
been neither observed historically nor anticipated by theory.
After the Great Depression and the Second World War, the banking system as a whole
was regulated, financial markets were far less developed than they are now, and banking
crises were less frequent and less significant. The historical experience of a wider
involvement of the central banks was forgotten, and economists as well as central bankers
then shared a narrow view of the LLR. Nowadays, central banks are placed in an
institutional framework in which financial markets and innovations are highly developed.
They have no choice but to go beyond the narrow conception of the LLR and adapt their
tools in consequence, for instance, through the enlargement of the category of
counterparties and that of the spectrum of eligible collateral and through the outright
purchase of a large set of assets. A line of interpretation would see such procedures as
exceptional or as a forerunner to a MMLR paradigm. But the fact is that a wider
conception of LLR has simply been rediscovered, just as the historical roots of lending in
last resort in a finance economy may be found in the classical period. The main
theoretical implication of this rediscovery is that, since the credit market is significantly
based on securities markets, the concept of the MMLR should be integrated into the
concept of LLR.
More than fifty years ago, Minsky (1957, pp. 185–6) anticipated these conclusions on
the need, in theory and in practice, for a broader view of the responsibilities of the lender
of last resort under a context of the development of financial markets and innovations.
“The evolutionary changes in the money market result from in both new kinds of assets
and new kinds on financial institutions. […] What is required to counteract the effects of
such evolutionary developments is a broadened view of central bank responsibilities […].
The classical Bank of England position was as a lender of last resort to a financial
intermediary, the discount houses, which, in terms of paper available, deeply penetrated
the British money market. A broad view of a central bank’s responsibilities includes the
maintenance of the stability of, and acting as a lender of last resort to, a broad segment of
the financial market. Hence as new financial institutions develop and as new types of
paper appear on the money market, such institutions and paper would not necessarily be
ineligible for central bank aid in time of crisis.”
14
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