Bagehot rule

In Lombard Street (1873), Walter Bagehot argued that, in a banking crisis, central banks should lend early and without limits to solvent firms against good collateral, albeit at a high rate of interest. Known as the Bagehot rule, this principle has been invoked when- ever there has been a serious banking crisis as the basis for the central bank's lender-of- last-resort policy.

Bagehot, influential as editor of The Economist magazine, developed his policy rule in response to the banking panics of 1847, 1857 and 1866. He argued that the Bank of England reacted late and with great reluctance in these crises. For instance, during the 1866 crisis, the Bank provided liquidity support only after the collapse of Overend, Gurney Company Bank contributed to a great banking panic. Bagehot approved of the Bank of England intervention, but suggested it would be better if the Bank officially acknowledged its role as lender of last resort, as only it could save the financial system in a crisis: "The only safe plan for the Bank is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent" (Bagehot, 1873, p. 90). The Bank of England therefore had a responsibility to support the liquidity of the banking system based on its role as issuer of money and manager of the country's reserves.

The Bagehot rule has been subject to quite different interpretations since it was first put forward in 1873. First, there is the recurrent issue of solvency. According to Bagehot, central banks should limit their support to illiquid but solvent firms. Yet this distinction can be hard to draw in the midst of a crisis. If solvency and liquidity problems could be so easily separated, there would not be a need for a lender of last resort. Also, the decision to lend or not to lend will always involve a substantial element of judgment, especially if the central bank chooses to take a long-term view of solvency (Stein, 2013).

Second, it is equally hard to determine what constitutes good collateral. This will require keen judgments of asset values, especially in situations where markets have ceased to operate properly. Bagehot (1873, p. 90) argued that if the market knew that the Bank of England would advance liquidity on "what in ordinary times is reckoned a good secu- rity", then "the alarm of solvent merchants and bankers will be stayed".

Third, there is the recurrent discussion of whether lending of last resort should be pro- vided at a penalty rate of interest. Many have argued that central bank support should be provided at a penalty rate of interest to limit moral hazard and secure early repayment of central bank assistance. It is interesting to note, however, that Bagehot did not use the term "penalty rate" in his book, but referred consistently to "high rates" of interest (Goodhart and Illing, 2002). He was concerned with the external drain or loss of gold, since England was on the gold standard at the time, and the high rate of interest was required to stem the outflow of gold. In a fiat money system with a floating exchange rate, this should be of lesser concern.

The Bagehot rule has gained new importance during the financial crisis that erupted in 2007, as central banks tested its limits and developed new and unconventional policy measures to combat the crisis (Bernanke, 2008). Traditionally, central banks would primarily provide liquidity to banks (or credit institutions) to support parity between private bank money and central bank money. During the 2008-09 crisis, however, some central banks also lent to non-bank financial institutions (investment banks and insur- ance companies) in order to protect the integrity of the wider financial system. Some central banks even supported financial markets, buying financial instruments to maintain orderly market conditions. This extension from traditional "lender of last resort" for banks to a much wider role as "market maker of last resort" was applauded by some, who looked at it as a new interpretation of the Bagehot rule for a modern money-market financial system (Carney, 2013).

Many central banks also extended the maturity of their extraordinary liquidity assis- tance and extended the list of eligible collateral. Despite these changes, many banks were reluctant to borrow, owing to the "stigma problem": common knowledge about their borrowing could worsen their financial conditions. To overcome this problem, central banks increasingly provided liquidity through anonymous auctions, where the identity of borrowers would not be publicly known. This has tended to blur the distinction between discretionary lender-of-last-resort liquidity loans and regular monetary policy opera- tions. The massive liquidity injections by central banks after the 2008-09 global financial crisis has thus led to a new area of unconventional monetary policy, with renewed discus- sions of the proper terms and conditions for central bank liquidity support, just like in 1873, when Bagehot's famous book was published (Moe, 2014).

See also:

Bagehot, Walter; Bank of England; Bank run; Central bank money; Collateral; Fiat money; Financial crisis; International reserves; Investment banking; Lender of last resort.