The development of the lender of last resort
In 1797, Francis Baring introduced the notion of the Bank of England as the “last resort” during the war between France and Britain. As the demand for liquidity increased and became general, English banks soon had no other choice but to turn to the Bank of England in order to avoid becoming illiquid. One century later, Walter Bagehot further developed and theorized the classical debate of the lender of last resort. The central bank should act as a lender of last resort according to four main principles:
1. It should lend freely:
2. It should lend at a penalty rate: the penalty rate (or high interest rate) aims at combatting moral hazard since the increase in liquidity supply can lead to risky lending. …show more content…
This occurs when a financail institution or bank in difficulty risks contamianting other banks or the entire financial system. The difficult part of this task is assessing ex-ante the degree of systemic risk an entity poses, especially since panic and loss of confidence rapidly become a self-fulfilling prophecy. Only when a systemic risk has been identified can a central bank provide liquidity to institutions in need. (Shoenmaker, RM …show more content…
The “too big to fail” theory suggests that the failure of banks or financial institutions that have become so large would lead to disastrous consequences. Central banks are faced with a dilemma: either saving financial institutions that have taken undue risks, such as the collapse of Lehman Brothers in 2008, and let the whole banking system collapse, taking down good banks as well; or saving those institutions and avoiding a catastrophe. The Fed and ECB both opted for the former case scenario. (Kenneth N. Kuttner
In 1797, Francis Baring introduced the notion of the Bank of England as the “last resort” during the war between France and Britain. As the demand for liquidity increased and became general, English banks soon had no other choice but to turn to the Bank of England in order to avoid becoming illiquid. One century later, Walter Bagehot further developed and theorized the classical debate of the lender of last resort. The central bank should act as a lender of last resort according to four main principles:
1. It should lend freely:
2. It should lend at a penalty rate: the penalty rate (or high interest rate) aims at combatting moral hazard since the increase in liquidity supply can lead to risky lending. …show more content…
This occurs when a financail institution or bank in difficulty risks contamianting other banks or the entire financial system. The difficult part of this task is assessing ex-ante the degree of systemic risk an entity poses, especially since panic and loss of confidence rapidly become a self-fulfilling prophecy. Only when a systemic risk has been identified can a central bank provide liquidity to institutions in need. (Shoenmaker, RM …show more content…
The “too big to fail” theory suggests that the failure of banks or financial institutions that have become so large would lead to disastrous consequences. Central banks are faced with a dilemma: either saving financial institutions that have taken undue risks, such as the collapse of Lehman Brothers in 2008, and let the whole banking system collapse, taking down good banks as well; or saving those institutions and avoiding a catastrophe. The Fed and ECB both opted for the former case scenario. (Kenneth N. Kuttner