Lender of Last Resort

BIBLIOGRAPHY

All advanced economies have relatively sophisticated banking systems. The commercial banks that make up the system operate on the basis of the law of large numbers. They accept deposits in the form of government-issued currency or transfers of cash reserves from other banks. The commercial banks then lend a large fraction of these reserves to businesses and individuals. This means that the claims of depositors against the banks exceed the banks’ holdings in cash reserves by a wide margin. Banks are able to operate in this manner because the law of large numbers is at work. A single bank has a large number of depositors, whose deposit and withdrawal patterns vary widely. On any given day, deposits and withdrawals largely cancel out, permitting banks to meet their necessary net payments with relatively small cash reserves. Banks are able to operate in this manner because depositors are confident that their banks will always honor their requests to transfer funds or make withdrawals.

A system that is based on confidence can collapse if confidence fails. If depositors fear that their bank might be unable to honor all their requests for funds, they may “run on” the bank: The law of large numbers breaks down as depositors attempt to withdraw their funds from the bank. Since most of the bank’s assets are tied up in loans that cannot be sold quickly to other financial institutions, the bank may have to stop payment.

In general, bank runs stem from one of two sources. Runs on individual banks may occur when depositors suspect that a bank is insolvent, that is, its net worth is negative. If the bank is in fact solvent (it has positive net worth), it should be able to borrow cash from other banks, enabling it to weather the run. General bank runs, affecting all banks in an area or throughout the economy, occur when depositors fear that the failure of other banks will trigger the failure of their own banks. Thus, depositors have the incentive to run on solvent banks. Because the bank run is general, individual banks cannot borrow from other banks, which are also under pressure. In the absence of a bank able to inject large quantities of legal currency into the banking system, the entire system is liable to collapse. A bank able to provide currency to the banking system in such situations is called a lender of last resort.

The importance of a lender of last resort to the banking system was recognized in 1797 by Sir Francis Baring (1740–1810), a London financier, and Henry Thornton (1760–1815), a London banker. Both argued that the Bank of England should respond to a large increase in the demand for currency by the English public by increasing the amount of currency issued by the Bank. Failure to meet the increased demand for currency would drain liquidity from the financial system, causing many solvent financial firms to fail. Widespread financial failure would be followed by an economic downturn.

Although the Bank of England did, on occasion, play the role of a lender of last resort (O’Brien 2003), the bank’s directors rejected calls to formally accept the role of lender of last resort, even after Walter Bagehot (1826–1877) made the classic case for it in 1873 (Bagehot [1873] 1999), further developing Thornton’s ([1802] 1939) analysis. The bank’s directors argued that promising to act as the lender of last resort would prompt banks to take on more risk, a behavior known as moral hazard. The result would be perverse: a lender of last resort might lead to more bank failures. In subsequent decades, the Bank of England held no larger gold reserves than it had before, refusing to commit to serve as Great Britain’s lender of last resort.

One of the purposes in establishing the Federal Reserve System in the United States was to improve the ability of the U.S. monetary system to meet increases in the demand for currency. Before 1914, the United States did not have a central bank, and increased demand for currency by rural banks during the harvest season resulted in several banking crises. The creation of the Federal Reserve System made it possible for commercial banks to obtain reserves by using short-term commercial loans as collateral for loans from the Federal Reserve banks. The United States experienced no liquidity crises from 1914, when the Federal Reserve System began operations, until the early 1930s, when the Federal Reserve’s failure to respond to large increases in the demand for currency contributed to the failure of more than ten thousand banks and to the severity of the Great Depression. Following the lead of Irving Fisher (1867–1947) and Henry C. Simons (1899–1946), Hyman Minsky (1919–1996) developed an argument in favor of a lender of last resort based on a financial fragility hypothesis. Minsky argued that overex-tension of credit by the banking system could lead to a general collapse of credit in the absence of a lender of last resort. In the post–World War II period, the Federal Reserve has acted on several occasions to prevent liquidity crises from developing.

SEE ALSO Banking; Banking Industry; Casino Capitalism; Central Banks; Federal Reserve System, U.S.; Financial Instability Hypothesis; Insurance; Law of Large Numbers; Lombard Street (Bagehot); Minsky, Hyman; Moral Hazard

BIBLIOGRAPHY

Bagehot, Walter. [1873] 1999. Lombard Street: A Description of the Money Market. New York: Wiley.

Minsky, Hyman P. 1975. John Maynard Keynes. New York: Columbia University Press.

O’Brien, Denis. 2003. The Lender-of-Last-Resort Concept in Britain. History of Political Economy 35 (1): 1–19.

Thornton, Henry. [1802] 1939. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Ed. F. A. von Hayek. London: Allen and Unwin.

Neil T. Skaggs