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Like the US Fed, the Bank of England (BOE) was, under its legal framework, required to be a market-oriented central bank and lender of last resort in the event of financial crises; prudential regulation was distributed between it and another independent agency. But its two-tier relationship was challenged by its method of crisis management selected during the GFC. This chapter will explain how its market-oriented commitment was changed as a result.

In the return to authentic central banking triggered by the financial disaster of 2008, and especially in the reassessment of the central bank’s role of lender of last resort, reference has often been made to Bagehot.

Iceland’s economic turbulence sounds like a familiar macroeconomic story — a credit expansion fuelled excessive borrowing and spending. But there are unfamiliar details — an unusually large banking sector and a central bank unable to serve as a credible lender of last resort — that raise concerns. Nevertheless, Iceland should be able to weather the current turmoil.

Iceland has developed an oversized banking system — with assets valued at eight times its GDP which has effectively transformed the country into a hedge fund. Domestic banks have borrowed heavily abroad to buy foreign banking assets, leveraging their capital base several times over. As a bust is following the global boom in the banking sector, the country is highly exposed to the current crisis. The lender of last resort in Iceland would not be able to save even one of the large domestic banks should write downs in the value of foreign assets bring any one of them into difficulties. Other European countries with financial centres have either avoided becoming lender of last resort for their banks (Luxembourg) or accumulated large foreign assets as a cushion (Switzerland). By contrast, Iceland’s extremely high net foreign debt ratio adds to the vulnerability of the country, which thus resembles a hedge fund with negative capital.

Iceland has, in a very short period of time, created an internationally active banking sector that is vast relative to the size of its very small economy. Iceland also has its own currency. This chapter argues that this ‘business model’ for Iceland is not viable. With most of the banking system’s assets and liabilities denominated in foreign currency, and with a large amount of short-maturity foreign currency liabilities, Iceland needs a foreign currency lender of last resort and market maker of last resort to prevent funding illiquidity or market illiquidity from bringing down the banking system.

A central bank is usually defined by its functions: responsible for the nation’s currency as the issuer of base money, the bank of the state, the bankers’ bank and responsible for lender of last resort (and in addition to this, the central bank is sometimes also defined as the supervising authority of the banking/financial system).

Preface Foreword The Canadian Monetary Order: Past, Present and Prospects Comments Canadian Monetary Policy Lender of Last Resort - Lessons from Canadian History Canadian Policy and the Economic Revolution in Asia Reforming Canadian Medicare: Can an Icon be Redesigned Tax Incentives for Owner-Occupied Housing - Then and Now The Political Economy of Inflation Targets: New Zealand and the U.K. Monetary Union Proposals in North America and Southern Africa: Do the Same Q&A Apply?

According to Minsky (1982, 1986), a crisis can be mitigated if, during the economy’s evolution from robustness to fragility, the central bank and fiscal authorities apply counteractive economic policies. These consist of acting as lender of last resort and running a large government deficit, thereby blunting the fall in profits. In other words, the seminal financial instability hypothesis (FIH) framework suggests an activist government may be able to block the endogenous evolution of expectations progressing to instability (see Part I and, with respect to Argentina, previous chapter). However, it is striking that during the recent financial crises in Latin America,1 such policies were, in most cases, not adopted.

The IFIs have enjoyed almost uncontested power for over two decades since the early 1980s. Several factors contributed to that, in particular the financial needs of highly indebted countries. In a context in which most developing countries were struggling for financial survival, the power of the lender of last resort shaped the policy options at hand for borrowing governments. In many countries, especially in Latin America, the influence of the IFIs was exerted through technocratic networks involving officials of the IFIs, particularly the IMF, the World Bank and the IDB, and high-level government officials in developing countries. Through regular interaction over time these networks became the carriers of neoliberal ideas and thus shaped reform in a neoliberal direction.

According to financial history books, the concept of lender of last resort dates back to 1797, when Francis Baring so described the Bank of England. A century later, the Bank of England (BoE) obliged by saving his institution from bankruptcy, but it did not repeat the gesture a second time in 1995, and the venerable Barings Bank went bankrupt; several economists applauded the decision not to intervene.

The state1 has a very influential position and permeates all of the Chinese banking industry. The state is shareholder, lender of last resort and also influences strategic, operational and managerial decisions throughout the banking system.

Thanks to the forced dissolution of the zaibatsu immediately after the war, Teikoku Bank and other zaibatsu-affiliated banks were freed from the control of the zaibatsu families. As a result, all of them became able to act as lender of last resort for major companies at their own discretion.

Excursion into swindles and other white-collar crimes perhaps takes us away from economic analysis of manis, panics, and the role of the lender of last resort. Nevertheless, it is inescapable. Commercial and financial crises are intimately bound up with transactions that overstep the confines of law and morality, shadowy though those confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut, induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft, embezzlement, or fraud.

Over the last quarter of a millennium “the Art of Central Banking”, as Hawtrey called it, has evolved the concept of a lender of last resort. The expression comes from the French dernier ressort, the legal jurisdiction beyond which it is impossible to take an appeal. But the term has become thoroughly anglicized, and in central-banking English it give greater emphasis to the responsibilities of the lender than, as in legal French, to the rights of the petitioner or borrower.

It is time to pull the threads of the argument together. But before we do, there remains one difficult, unanswered question: Does it make a difference if there is no lender of last resort? For one thing, for most of the financial crises covered from 1720 to 1988, both national and international, a lender of last resort did swing into action in response to the pressures of the market—though often protesting all the way. The role was not always dispatched with efficiency, so that a refined analysis would categorize the aftermath of crises not only by the presence or absence of a lender of last resort but also by how well the role was discharged. Second, the aftermath of a depression depends not just on how the crisis was handled but on a host of other variables, especially the factors affecting long-term investment: population growth, the existence of a frontier, demands arising from war, exports, the presence or absence of innovations that are not fully exploited, and the like. A speculative crisis like that of 1847 in England was likely in any eveny to be pulled quickly back into prosperity by renesed investment in railroads, regardless of whether the Bank of England suspended the Bank Act of 1844 and stood ready to provide liquidity to all borrowers with sound collateral.

Assume plethora, speculation, panic, as in the epigraph from Walter Bagehot. What then? The management of crises will occupy the next three chapters. This, the first, will consider initially the possibility that the best remedy for panic is to leave it alone, letting it run its course. We then discuss a variety of assorted expedients that have been used in the real world, short of issuing new money through a lender of last resort. The two chapters that follow consider the role of the lender of last resort, first domestically in Chapter 10, then internationally in Chapter 11.

This article explores the nature of the main bank in its roles as the major creditor and lender of last resort to its clients within Japanese banking’s cultural, historical and institutional context, and in relation to governmental institutions that strive to foster economic development through the main bank system. In so doing it discloses some of the myriad formal and informal systems which the main bank uses to structure a profitable and lasting relationship with its client firms, the nature of the direct rewards sought by the banks, and how their needs are served by the main bank relationship.

PKE monetary and financial theory has essentially developed around the theme of the endogeneity of money, which is seen as depending minimally on three types of behaviour. These are the behaviour of the central bank, the lending behaviour of the commercial banks, and the borrowing behaviour of the non-bank private sector. Under a fixed exchange rate regime we should also include the overseas sector. As regards domestic sources of endogeneity, the standard argument in PKE is that the central bank, as lender of last resort, has no realistic alternative but to satisfy the needs of trade at the discount rate that it fixes (see for example, Kaldor, 1980; Moore, 1988). Commercial banks then provide credit at the discount rate fixed by the central bank plus a mark-up. The demand for bank lending is interest inelastic. This is the standard argument in some, if not in most, PKE monetary and financial theory.

I perhaps owe my readers an apology for referring once again to the doctrine of lender of last resort. The late Fred Hirsch brought the subject to the forefront of discussion with a brilliant paper half a generation ago (Hirsch, 1977). Hugh Rockoff discussed it earlier in this series honouring Henry Thornton (1986). Governor Carlo Ciampi of the Bank of Italy lectured on the subject in his own country in February of this year (Ciampi, 1992). The issue has been pursued in at least two of my books (1986, Chs. ix, x; 1993, passim, but especially pp. 277–83 of the 1984 edition). On this occasion, however, my purpose is not to defend the doctrine in the face of monetarists who believe that the money supply should be fixed, or grow at a fixed rate, rather than be allowed to expand in periods of widespread illiquidity and distress. That issue, to my mind, has been settled in favour of a lender of last resort in financial crisis. Rather, I suggest that the world may have pushed the doctrine too far with deposit insurance for commercial banks and thrifts, the rescue from bankruptcy of such bodies as New York City, some corporations such as Penn Central, Lockheed and Chrysler Corporation, banks ‘too big to fail’ even though their deposits exceed insured limits by wide margins, brokerage houses that loaned to such a commodity speculator as Bunker Hunt, who tried to corner the world silver market in the early 1980s. Even now in Japan, government money is called upon to make whole an institution owned by a rich bank, the troubles of which were caused by fraud rather than mistakes (The Economist, 1992, p. 105). Many high-minded principles suffer from entropy or decay over time, and the lender of last resort may be one of them.

We end our present treatment of banking by considering some recent theoretical work on banking instability. This work has attracted considerable attention, and purports to provide rigorous theoretical justifications for government deposit insurance and other features of modern central banking. The key paper in this new literature is Diamond and Dybvig (hereafter DD, 1983). This paper posed two questions that have dominated the subsequent literature. First, why are financial institutions subject to instability and, as a subsidiary question, why is this instability damaging? Second, what, if anything, should the government or central banking authorities do about this instability? DD suggested that the instability arises because depositors’ liquidity demands are uncertain and banks’ assets are less liquid than their liabilities, and they suggest that the instability is harmful because it ruins risk-sharing arrangements and damages production. They also argued that this instability creates a need for government deposit insurance or a lender of last resort to provide emergency loans to banks. Later literature in the DD tradition develops these answers further and has been used to justify additional policies such as interest-rate ceilings (e.g., Anderlini, 1986b; Smith, 1984) and reserve requirements (e.g., Freeman, 1988).

Even the most unreconstructed monetary libertarian would be hard put to it to controvert the rationale for at least a basic regulatory and supervisory framework for the banking and financial system, a position which, however, leaves room for legitimate debate on the extent, nature, scope, and forms of regulation. This is an area which raises a whole cluster of critical interrelated issues. What, in fact, is the case for regulation, or re-regulation, now that liberalization and deregulation of the financial system are an accepted policy objective and most developing countries are well-set on the path to substantial liberalization? Is the central bank necessarily the most appropriate agency for supervision? What are the typical problems encountered in supervision, and what measures are necessary and desirable to enhance the efficiency of the supervisory process in developing countries? What is the appropriate role for the central bank as a lender of last resort? Is deposit insurance a necessary adjunct to the prudential framework of the banking system?

In recent years we have become much more aware that modern capitalist economies are susceptible to periodic financial crises. In the past the visibility of these episodes was elaborated with such colourful names as the Panic of 1907 and the Panic of 1893. Their visibility in the early part of the twentieth century, however, hardly needed elaboration, for they often led to sharp crashes of the financial system and deep depressions. In more recent times, macroeconomic policy and operations by the central bank as a lender of last resort have mitigated the implications of financial crises for the stability of the economy. Nonetheless, close study of these phenomena indicate that the potential for serious repercussions on the financial system and the real economy still exist.

The early history of Central Banking led to the functions of monetary management and the role of Lender of Last Resort being combined within the nascent Central Bank (see Goodhart, 1988). Where established, (e.g. in Sweden, UK, France, Italy), the Central Bank was the government’s bank, and, until the latter part of the 19th century, generally the largest bank within the economy. As such, it was assigned the overall responsibility, explicitly or implicitly, for maintaining currency convertibility into specie, the prime function of macro-monetary management until 1913.

Politicians, bankers and economists have at various times and again in recent years started to urge that there be created an ‘international lender of last resort’. Depending on the context, the ‘international’ role is thought to cover either the European Union, or, in some particularly ambitious proposals, the world as a whole, with the IMF sometimes suggested as taking on the role of worldwide lender of last resort (LLR). In every case, the objective is to ensure the stability of national banking systems — either within the EU or worldwide. The purpose of this chapter is to consider the international LLR proposal from three aspects — analytical, historical and, to some extent, that of the history of economic thought; the primary focus is on theory and history. The chapter is in four main sections.

In a paper presented in March 1989 at a meeting held in Perugia in which die instruments for safeguarding the stability of the financial system were debated1,1 expressed the view that, while the functioning of money markets and the precision of tools for monetary control had been greatly ameliorated, paradoxically no significant improvement had been achieved in instruments aimed at direct channelling of lender-of-last- resort funds to banks which experience temporary and intense liquidity stresses. This situation, which appears to be particularly harmful in the case of banks which are submitted to reorganisation procedures under the supervision of regulatory authorities, was to be attributed to the survival of an outdated and rigid legislation governing the eligibility of assets to be acquired by the Bank of Italy as collateral to refinancing operations on a bilateral basis, and it was sharply in contrast with the continuous refinement of the instruments which monetary authorities can negotiate in open markets for purposes of monetary control.

This chapter presents some public policy conclusions which can be derived from the theoretical reasoning and the empirical evidence presented in the preceding chapters. In particular, it looks at the implications for European competition policy and develops some policy proposals for preserving financial stability in a European retail financial services market increasingly characterised by cross-border activities. For the latter question, it focuses on the question of home country versus host country provision of deposit insurance and lender of last resort facilities which are the two main regulatory tools to attempt to make financial systems ‘run-proof’.

The term ‘lender of last resort’ implies a degree of specificity that goes beyond what that function can legitimately claim. I have never seen, in visits to central banks, a door marked ‘lender-of-last-resort department,’ nor met a vice-president in charge of such an activity.

The new money markets that came into being from about the mid-1950s are usually called ‘parallel’ markets because they developed alongside the traditional discount market, which they rapidly overtook in size. This term is, however, misleading since it obscures the extent to which the new markets were interlocked in a complexity of operations which it is impossible to unravel statistically. Solely for clarity of exposition, the markets can be divided into (a) the local authority markets, (b) the sterling and currency interbank market, (c) the negotiable certificate of deposit market and (d) the eurodollar and eurocurrency markets. The new markets differed considerably from the traditional discount market; all lending was unsecured, there was no lender of last resort, loans were not self-liquidating and the authorities had no direct control over the flow of funds through them. All the markets provided the non-clearing banks with an opportunity, which for most of them had not previously existed, to develop deposit banking and thus to expand their deposit liabilities on the basis of which they could engage directly in commercial lending. Statistics illustrating the rapid growth of these markets, and the related finance house market, are shown in Table 6.1.

Many of the problems in the international relations of interdependence arise from a combination of the free rider problem, Olson’s problem,1 and the prisoners’ dilemma. Indeed, the free rider, or contributor’s, dilemma is a special case of the prisoners’ dilemma. The free rider problem exists because some of the solutions of international difficulties consist in the provision of public goods (Kindleberger, 1978, p. 15 and 1986). A public good is one from the supply of which all those who value the good derive some benefit, irrespective of whether they have contributed to its costs. The concept can readily be extended to cover common goals or common interests, the achievement of which benefits all, irrespective of whether they have contributed to the costs of achieving these goals or interests. The enjoyment of the good or service by one person does not detract from the enjoyment by others. In this sense international co-operation and the prevention of international wars are public goods. So are markets and a working international monetary order, with an international central bank as a lender of last resort and as a provider of liquidity. Scientific research is of this kind. An international income tax or the co-ordination of international fixed investment decisions fall under the same heading.

The paper that follows was written several months ago. Comments from several readers and further reflection have convinced me that some matters warrant clarification.2 I have not revised the body of the paper, but will address some of these matters in this prologue.

Notes on the Contributors - Introduction R.Z.Aliber - PART 1 THE RECENT PAST - The Evolving International Monetary System: Past Plans and Optimality H.G.Grubel - Unexpected Real Consequences of Floating Exchange Rates R.McCulloch - Toward a More Orderly Exchange Rate System J.R.Artus - The Wage and Price Adjustment Process in Six Large OECD Countries R.J.Gordon - Fixed Exchange Rates, Flexible Exchange Rates, or the Middle of the Road: A Re-examination of the Arguments in View of Recent Experience H.Genberg and A.K.Swoboda - PART 2 INTERNATIONAL RESERVES AND INTERNATIONAL MONEY - Internationally Managed Money Supply G.M.von Furstenberg - Changing Perceptions of International Money and International Reserves in the World Economy K.A.Chrystal - Gold: Does it Provide a Viable Basis for the Monetary System? R.N.Cooper - Gold in the International Monetary System: A Catalogue of the Options R.Z.Aliber - Gold Monetisation and Gold Discipline R.P.Flood and P.M.Garber - Gold in the Optimal Portfolio D.A.Hsieh and J.Huizinga - An Analysis of the Management of the Currency Composition of Reserve Assets and External Liabilities of Developing Countries M.P.Dooley - The Theory of the Lender of Last Resort and the Eurocurrency Markets J.R.Shafer - The Endogeneity of International Liquidity P.M.Oppenheimer - Index