Believe those who are seeking the truth. Doubt those who find it. Andre Gide

## Thursday, December 1, 2011

### On Bagehot's Penalty Rate

What principles should govern the way a lender-of-last-resort (LLR) operates during a financial crisis? On this question, one is frequently referred to two key principles, attributed to Walter Bagehot in his book Lombard Street. The two principles are usually summarized as "lend freely and at a penalty rate." What does this mean?

In "normal times," firms regularly borrow cash on a short-term basis (say, to meet payroll). These loans are usually collateralized with a host of assets (e.g., accounts receivable, property, securities). The dictum "lend freely" in this context means to extend cash loans freely against the collateral that is normally put up to secure short-term lending arrangements.

The rationale commonly offered for the LLR is that during a crisis, "perfectly good" collateral assets are either no longer accepted as security for short term loans, or that if they are, they are heavily discounted (e.g., a creditor will only lend 75 cents for every dollar in collateral, instead of the usual 99 cents). Whatever the ultimate cause, this type of "liquidity crisis" creates havoc in the payments system. This havoc can be avoided, or at least mitigated, by a LLR that stands ready to replace the "missing" lending activity. (Or so the story goes.)

Let's say that the normal discount rate on high grade collateral is 0 < d < 1. So if a creditor offers to lend \$99 for every \$100 in collateral, d = 0.01 (one percent discount). Let's suppose that during a crisis, the discount rate rises to c > d. (If c = 0.5, then there is a 50% discount or "haircut" on collateral.) One issue that the LLR must address is the discount rate it should offer on an emergency loan. Let me call this discount rate p.

Now, if the LLR sets p = c, then what is the point of having an LLR? So clearly, if the LLR is to influence lending activity in any manner, it must  set p < c. Opponents of LLR activity like to label p < c a "bailout." (This term is rarely defined precisely; it appears to be a label to attach to programs that one does not like.)

At the other extreme, the LLR could set p = d. In this case, the LLR is discounting collateral in the same way that the market does during "normal" times. If the LLR instead set p > d, it is charging a "penalty rate." (Note: I do not think that Bagehot ever used this term.) How should the LLR set this penalty rate and why? Here is Bagehot:
First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who did not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. (emphasis, my own)
Well, O.K., so he does not appear to answer the question of what discount rate to apply; only that it should be "very high." But I am less interested here in the precise penalty rate as to the rationale for why a penalty rate is necessary. A colleague of mine (who appears to have done a great deal of reading in the area) suggests that the rationale was primarily to ensure that the Bank of England did not run out of reserves (an event that would have led to its failure, and the subsequent end of civilization in the minds of many at the time).

Of course, the Federal Reserve Bank of the United States does not face the prospect of running out of cash reserves, the way that the Bank of England did back then. This is because "cash" back then took the form of specie (gold and silver coin). "Cash" today takes the form of small denomination paper notes (and electronic digits in reserve accounts) that the Fed can issue "out of thin air." In light of our modern institutional structure, I wonder whether Bagehot, living in today's world, might not have dropped his "penalty rate" dictum?

Is there any good reason left for the penalty rate? Perhaps there is. But it is clearly of second-order importance during a financial crisis. First, lend freely. It is probably not the time to worry about this penalty rate or that penalty rate in the depths of a liquidity crisis. If an institution is deemed, after the fact, to have benefited "unfairly" at the expense of society during an emergency lending episode, then a "fee for service" (i.e., tax) could be applied after the crisis has passed.

P.S. Would be interested to hear from historians on this subject.

Postcript: January 30, 2012
I would like to thank Josh Hendrickson for sending me the link to this paper:

Abstract: Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wisdom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insolvency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios.

1. I'm not commenting directly in response to your request. However, while I see where you're coming from, I'm having problems with your example where 0.5 = c < d = 0.01.

2. Jamus: The problem with my example is that I cannot do simple math! Thanks for pointing out the error. I think it is corrected now.

3. If the LLR is going to set the discount rate extremely low, what is the difference between an institution that is insolvent as oppose to having a liquidity issue?
It seems to me that under this model, any insolvent bank/government with the right connections could indefinatley claim just a liquidity problem.
How would an LLR that leaves taxpayers on the hook for losses deal with this issue.

4. Edward,

In practice, I think it must be very difficult to make the distinction.

However, after repeated experiments, I suppose that the proof can be found in the pudding. We can ask, for example, how much money the Fed actually lost on its emergency lending operations over its existence (the Fed in fact made money for the US taxpayer over the recent crisis, though some argue not enough to compensate for the risk it adopted).

5. A penalty rate exposes banks that cannot pay it because they are insolvent. A liquidity crisis is a "lemons" problem, and finding and eliminating those lemon firms is no small matter: it leads to a more robust system after the liquidity event. Keeping those firms alive intact results in a "zombie" financial system with healthy banks holding large precautionary balances and withdrawing from interbank lending. Today, we have Citi, BofA, and many large European banks that are among the walking wounded.

The question I would ask myself, as a Fed official, is how we ended up with a financial system that cannot deliver any losses to its creditors without being in danger of collapsing.

6. The penalty rate is obviously a penalty for poor liquidity management, and to discourage banks from using the "lender of last resort" as a permanent source of funds, by making it expensive and thus giving an incentive to repay the loans as soon as possible when liquidity is back.

But our blogger is clearly on the bandwagon of those who want to confuse the role of lender of last resort (expensive loans on good collateral repaid as quickly as possible) and that of donor of last resort (monetizing debt with cheap pretend-loans based on worthless pretend-collateral).

This is made clear by his facetious accompanying remark that:

«the Fed in fact made money for the US taxpayer over the recent crisis,»

which seems to be like pure propaganda based on disregarding immense subsidies and accounting tricks enjoyed by the same banks to keep them alive and make them look as if they were solvent and profitable as is well explained by Waldman here:

http://www.interfluidity.com/v2/2587.html
«Bullshit.»

And nobody mentions Maiden Lane and the other black holes anymore.

But in particular since the FAS157 change nobody outside them knows for sure whether the major banks that the Fed/Treasury bailed out "at a profit" are still solvent.

Of course this means that they are not solvent, even with the immense subsidies, and the bailout and "profits" were just operatic ("extend and pretend" is the title of the libretto).

The debate on the "donor of last resort" role is just about the state keeping deeply insolvent situations going long enough for insiders to liquidate their positions and tunnel themselves another round of bonuses.

To me this looks like enabling bankruptcy fraud, which is a long standing Real American value, as reported by Tocqueville:

«Consequently, in the United States the law favors those classes that elsewhere are most interested in evading it. It may therefore be supposed that an offensive law of which the majority should not see the immediate utility would either not be enacted or not be obeyed.

In America there is no law against fraudulent bankruptcies, not because they are few, but because they are many. The dread of being prosecuted as a bankrupt is greater in the minds of the majority than the fear of being ruined by the bankruptcy of others; and a sort of guilty tolerance is extended by the public conscience to an offense which everyone condemns in his individual capacity.
»

7. «The question I would ask myself, as a Fed official, is how we ended up with a financial system that cannot deliver any losses to its creditors without being in danger of collapsing. »

Well, quite deliberately, because that is the most profitable (in return-on-capital terms).

But that's not really the major issue. The major issues with saving banks and their creditors are:

* Nobody should care about the collapse of the financial system as such, except that astutely those running it have been holding the payment system and saving system hostage, and those are in effect public goods. Major FIRE interests have been busy merging financial speculation and payment and savings operations to make it impossible to save just the latter.

* Most creditors in the first-world are pension funds and older women (widows and divorcees). The so called "rich" and banks are usually debtors who control rather than own financial wealth. Governments cannot tell pensioners and older women that their properties were speculated and tunnelled away by the financial system, because they are very powerful voting blocks.

8. The idea is to reduce the gap between the cost of holding deposits and the risk premium. In the current crisis, we have seen risk premiums for most borrowers skyrocket. Meanwhile, interest rates banks must pay to hold deposits are below inflation. Lend freely but at a penalty rate gives banks plenty of money to lend AND the penalty rate reduces the spread between the cost of deposits and the risk premium.

The dictum applies to banks and not individuals. We make transfer payment to individuals to create demand. Banks make money by leverage, the borrow short and lend long. By lending freely, the government is covering the reserve requirements of the banks. By lending at a penalty rate, it forces the banks to make riskier loans to get return on investment from the backing they receive.

This is because the risk premium for most loans increases in a recession. Unless the recession is created to slow demand, money must be lent to increase demand. The penalty rate is the rate that forces banks to make risky loans. The "lend freely" covers the expected losses from making riskier loans.

The strategy (like all strategies) has its limits. The rate of default is linked to the cost of borrowing. If cost of borrowing is too high, borrowing will be unaffordable and increase default. That is why fiscal stimulus to directly supply goods and services to people with unmet demand is a necessary adjunct. It lowers the risk premium of these "potential borrowers".

9. Anonymous @Dec 1, 9.56PM

Sure, solving the lemon problem is difficult. In a liquidity crisis, the market tends to throw the baby out with the bathwater. The issue is whether the disruptions in payments that ensue might somehow be mitigated by an intervention. You seem to think not. Others disagree. It is an ongoing (and interesting) debate.

Blissex:

Before choosing to foam at the mouth and spewing nonsense, read what I write.

Anonymous @5.15PM

Yes, perhaps so. But would you agree with me that the management of the penalty rate is of second-order importance during a crisis (and that Bagehot today may have felt the same way)? There may be more efficient ways to discipline behavior (moral hazard, etc.).

Also, what is your explanation for why the Fed's emergency lending facilities were wound down so rapidly? (This is an open question.) If they constituted such a great subsidy, why did they not persist?

10. David, I think you misconstrued my comment. There is a need for an LLR role so payments are not disrupted. Without a penalty rate, insolvent banks may survive that liquidity event. Without knowing that the system has been cleansed of lemons, the rest of the banks will have higher precautionary balances and shy from interbank lending. In other words, failure to charge a penalty rate comes at the cost of lower future liquidity and higher fragility.

At the end of the day, the only reason not to charge a penalty is because the fiscal agent is not in a position to resolve insolvent banks. This might be because of a lack of political will, or a lack of resources (both are true of France today).

11. Anonymous, sorry, I appear to have misunderstood your argument. As for your concluding paragraph, I would have to agree if it was indeed the case that the fiscal agent was somehow prevented from recouping what it believes is owed. My own concluding paragraph assumed that the fiscal agent has little problem in levying taxes, but this may not always be the case, as you point out. Thanks.

12. «Without a penalty rate, insolvent banks may survive that liquidity event.»

But this makes no sense. For two reasons:

* The Bagehot rule is to lend against good collateral. If the insolvent banks have good collateral, they are not insolvent. If they don't have good collateral, they are insolvent and cannot get the lender of last resort to lend to them at all.

* Bagehot very explicitly says as quoted by the blogger, who then ignores this, that the penalty rate is «prevent the greatest number of applications by persons who did not require it»» and the intent in general is to make sure that the lender of last resort loans are very short in duration. Therefore in absolute terms the cost of the penalty interest will not be high, and many insolvent borrowers don't mind paying a high rate of interest for a while to stave off bankruptcy.

Again, Bagehot is all about lender (not donor) of last resort operations, in case of a panic.

Panics don't just "happen" in banking, they are usually triggered by actual or suspected insolvency in that case the demand for good collateral immediately sorts out the lemons from the solvent.

This has been very obvious in the 2008 situation, when the donor of last resort extended credit on toxic collateral, as not extending credit to insolvent banks who could not have produced good collateral would have exposed them as insolvent, and the donor of last resort strategy was to extend and pretend.

That the donor of last resort also charged concessionarily low rather than penalty high interest on those loans extended on toxic collateral was simply to help the insolvent banks earn money on the spread, which as reported recently by Bloomberg happened on a grand scale.

13. BTW I have indeed not read well the blogger's original post, as only now I notice that he is gravely misrepresenting Bagehot's principles by omitting the third one here:

«The two principles are usually summarized as "lend freely and at a penalty rate."»

because the third principle is indeed "against good collateral", as confirmed by his magazine here:

http://www.economist.com/node/9653092
«In “Lombard Street”, his 1873 account of the money markets, Walter Bagehot urged the Bank of England to stave off such panics by lending “quickly, freely and readily”, at a penalty rate of interest, to any bank that can offer “good securities” as collateral.»
«But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.»

I think that the blogger's article is discussing soemthing very different from the Bagehot rule, and that the quotes above summarizing Bagehot's own rationales are all that is needed instead of misleading speculation on a critically truncated rule.

Because Bagehot very clearly was not intending the lender of last resort to extend low cost credit towards insolvent banks offering toxic collateral and to act therefore as a donor of last resort.

14. «By lending freely, the government is covering the reserve requirements of the banks. By lending at a penalty rate, it forces the banks to make riskier loans to get return on investment from the backing they receive. This is because the risk premium for most loans increases in a recession. Unless the recession is created to slow demand, money must be lent to increase demand. The penalty rate is the rate that forces banks to make risky loans. The "lend freely" covers the expected losses from making riskier loans.»

Again, to me this seems completely different from the Bagehot principles.

The Bagehot principles are about the behavior of a central bank (not the government), and about addressing a banking liquidity panic (not a recession), and are not meant to give incentives to banks to make riskier loans to support real economy spending.

However I agree in part that:

«the only reason not to charge a penalty is because the fiscal agent is not in a position to resolve insolvent banks. This might be because of a lack of political will, or a lack of resources»

because you are here talking of the situation where a government or central bank acts as donor of first resort, when they extend credit at concessionary rates against toxic or no collateral, and that's obviously because they don't want or cannot close resolve insolvent banks.

15. Oops, looks like that a comment of mine got lost of perhaps was filtered because it contained a URL. Again without the URL (and two small changes):

BTW I have indeed not read well the blogger's original post, as only now I notice that he is gravely misrepresenting Bagehot's principles by omitting the third one here:

«The two principles are usually summarized as "lend freely and at a penalty rate."»

because the third principle is indeed "against good collateral", as confirmed by his magazine here:

from "The Economist", 16 August 2007, "What would Bagehot do?":

«In “Lombard Street”, his 1873 account of the money markets, Walter Bagehot urged the Bank of England to stave off such panics by lending “quickly, freely and readily”, at a penalty rate of interest, to any bank that can offer “good securities” as collateral.»
«But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.»

I think that the blogger's article is discussing soemthing very different from the Bagehot rule, and that the quotes above summarizing Bagehot's own rationales are all that is needed instead of misleading speculation on a critically truncated rule.

Because Bagehot very clearly was not intending the lender of last resort to extend low cost credit towards insolvent banks offering toxic collateral and to act therefore as a donor of first resort.

16. Blissex,

You seem to misunderstand me. I explain in my post what Bagehot meant by lending freely. It means lending freely against assets that are regularly used as collateral in normal times. The presumption here on my part is that this class of assets are "good," in part because (I suppose) they have stood the test of time. Also, as Bagehot points out, it is unlikely that in aggregate that such a portfolio is going to be toxic (even if a small fraction turn out to be).

The last sentence you highlight from the Economist is irrelevant in that it represents the writer's interpretation of Bagehot. I provide a direct quote from Bagehot where he stresses the need for the BoE to avoid running out of reserves. I am speculating that Bagehot may not have insisted on his "penalty rate" dictum in today's day and age. Or perhaps he would have, but for other reasons? I don't know. I just brought it up for discussion.

17. I agree with Blissex that modern central banks seem determined to prop up ailing banks as fiscal "donors" rather than lenders of last resort. Its understandable that they want to downplay moral hazard as, "something to worry about tomorrow." The wonder, though, is why they don't seem to recognize that tomorrow has arrived.

18. On some corner cases...

My summary: in the Bagehot case, which is about banks (lenders), and good collateral (lender capital in effect), the penalty rate is to make sure the emergency discount window is used as little as possible, as he wrote explicitly, and the good collateral is to ensure that liquidity is not extended to the insolvent banks, only the illiquid ones.

The assumption is that the penalty rate is a fine paid by the shareholders of the bank either out of current profits or out of capital, and the total cost is small anyhow because the liquidity loans are of short duration (because the penalty rate is high).

But it can happen that a lender is solvent but not by much, and paying a penalty rate during a panic would make it insolvent, at least marginally. In the case of banks one can argue that however marginally insolvent banks are the norm, and anyhow the test of solvency in Bagehot's case is the good collateral, not whether it can afford to pay the penalty rate, and anyhow marginal insolvency can be fudged (which is the reason why banks try hard to be at least marginally insolvent, as it is more profitable).

There is a similar case today: Italy. Their debt is solvent if the rate is low, and insolvent if the rate is high.

But note that Bagehot's rule cannot apply to sovereigns because they are not banks, and most importantly there can be not collateral.

Also sovereigns are not banks, they are borrowers, not lenders.

The true rationale and applicability of Bagehot's rule is to banks because almost by definition a bank explicitly borrows short term and lends long term against collateral, so it can be subject to a liquidity problem simply because the short term borrowing can become insufficient even if the long term loans are good and backed by good collateral.

The problem here is purely the term structure, if one assumes that eventually the short term borrowing will resume, and assess correctly that the collateral is good.

A bank *customer*, that is a borrower, instead has a completely different financial structure. For example a manufacturer can go through something that looks like a temporary liquidity crisis, if for example it has funded production via loans and it suffers a fall in sales that do not allow it to generate enough cash flow to service the debt. The Italian case is similar to this.

The thing with the fall-in-sales business scenario is that it is not a liquidity problem: it is an insolvency problem. Because whether the fall in sales is temporary or permanent is not a liquidity issue, it is a business issue. It requires making an investment decision, that is supplying equity to the business, subject to business risk, not liquidity risk, because the fall in sales might indeed be a fundamental problem with the business. Put another way if the business cannot survive a period of slow sales it is undercapitalized, not illiquid.

Another vital difference between the business and the bank case is that the usually the business in the case above does not have collateral to support a "liquidity" loan because it has already used it to support the "business" loan it cannot service. It is a difference because banks do not usually offer collateral to their depositors and other sources of short term funds, but require them from their borrowers.

Put it yet another way Bagehot's rules were intended for the case of a bank run, not for the case of insufficient sales.

In the sovereign case the issue profile seems much nearer to that of insufficient sales than to that of a bank run.

Therefore the lending decision should not be based on the Bagehot rules, but the usual principle used by banks or venture capitalists deciding whether to throw some money into a risky situation: future cash flow, not quality of collateral.

19. Now a serious complication comes from the case where the two scenarios overlap: there is a run on a bank (liquidity panic) because it has lent to a business (or sovereign) that has insufficient cash flow and collateral to service their loans if not now in the the future (business insolvency).

In that case everything hangs on whether the collateral posted by the bank for discount at the lender of last resort is deemed good or not, because in that case that collateral must be the impaired debt of the business or sovereign (because if there is enough other collateral the run on that bank would not happen).

I would reckon that Bagehot would consider that bad collateral, because his rule is about safe collateral, and the business/sovereign collateral at the root of the bank run is obviously being questioned by the markets.

So it is really a case where the lender of last resort has the opportunity to fudge it: to appear like a lender of last resort by extending loans to banks suffering from a bank run, but being really a donor of first resort by accepting collateral that is deemed unsafe by the market.

There may also be the circular problem that the unsafe collateral is deemed such only because the rate is too high because it is deemed unsafe, so the lender of last resort accepting it and lending at a low rate breaks it.

But what is a safe lending rate on a marginally solvent business/sovereign borrower which may or may not spiral out or into insolvency is again an investment decision and should be supported by equity not temporary loans.

In the business case the situation is usually clear: businesses that have cash flow problems get put into administration (chapter 11 in the USA), and they may get lender-in-possession loans or new equity or else put into liquidation (chapter 7 in the USA), and banks that lent too much to them are also put into administration waiting for the borrower mess to be resolved. That does not apply to the world of TBTF banks and their sovereign borrowers.

In past cases lenders of last resort have only been happy to fudge it massively for their TBTF friends-of-friends (in the USA massive loans apparently were secretly extended to banks without collateral and without interest to get them over "liquidity" issues, and before that the Bank of England famously lent against whatever in panics at least some time in past centuries).

But that seems quite outside Bagehot guidelines, which are really about safe collateral and bank run panics. Perhaps new guidelines are needed (and Buiter etc. proposed some new ones).

Or perhaps governments everywhere should stop using the fig leaf of central banks and lenders of last resort to solve what are in essence credit and not liquidity risk issues, voters should be be less hypocritical and gullible and reward them for doing so, and the central bank should lend a pony at a zero interest rate without collateral to every
little girl (think of the fantastic PR! :->).

20. As the link below shows, back in August of 2007, Commerzbank's liquidity problems sparked a run on bank wholesale funding. According to Der Spiegel tonight, Commerzbank may soon be nationalized. "Tomorrow" has indeed arrived.

21. Hi David,

This is a good post.

I think you have captured an inconsistency in the Bagehot principle. If the guiding rule is to lend at a penalty rate, then during a liquidity crisis how can the central bank ever fulfill its duty as lender of last resort? The rate that the market requires will rise but the penalty rate will rise even more, such that the central bank effectively prices itself out of the market. After all, if you can transact with the market at x%, why transact at x+1% with the LOLR? Some liquidity provider that is.

At the same time, I'm sure we can all agree that the job of a LOLR is to provide liquidity, not set market prices.

I think the problem here is that we haven't learnt how to properly understand and measure liquidity, and therefore can't price it and provide adequate liquidity insurance policies. Central banks certainly aren't great at it. Because their tools are so blunt, as an unfortunate by-product of acting as LOLR they clumsily prop up asset prices. And that gets everyone angry, and justifiably so.

The best solution would be to devolve the provision of liquidity insurance to the market. Financial products would be developed to provide superior measures of liquidity, and the prices of liquidity for various assets would become public. Taxpayers would no longer have to worry about subsidizing sloppy efforts to provide liquidity to those who may not have paid the market price for the benefits the Fed provided them.

22. "So clearly, if the LLR is to influence lending activity in any manner, it must set p < c"

you are implicitly assuming all borrowers have access to the market (and thus can only benefit if p<c). this assumption does not hold in practice.

23. «guiding rule is to lend at a penalty rate,»

The guiding rule is to lend against good collateral (that is to solvent banks) at a penalty rate during a liquidity crisis»

«the penalty rate will rise even more, such that the central bank effectively prices itself out of the market. After all, if you can transact with the market at x%, why transact at x+1% with the LOLR?»

If one can borrow at x%, there is no liquidity crisis.

During a liquidity crisis there is insufficient quantity of liquidity; the cost of credit is irrelevant because lenders simply cannot borrow enough.

This is very basic principle of central bank work, and you seem to completely misunderstand or misrepresent the topic under discussion.

«The best solution would be to devolve the provision of liquidity insurance to the market.»

Nobody is forbidden from selling that to the market.

If you want to make a lot of money fast by selling liquidity insurance for cheaper than the Fed or the ECB do please go ahead, they will be quite pleased to be relieved of a politically difficult job.

24. David:

You might say that a solvent bank can be forced into insolvency by having to sell assets at fire sale prices. I'd say that bank was never solvent to begin with, if it couldn't stand a run. So a loan to such a bank is actually a gift, and an ill-advised gift.

Better to leave banks on their own, and they'll come up with their own ways of handling runs: suspension clauses, delayed payment clauses, etc. If fewer people keep their money in banks as a result, then that's just the invisible hand doing what it's supposed to do.

25. Very good post, as usual. Sorry for not to answer to the interesting Bagehot´s problem , but I think my question is quite related.
I have a great dilemma about monetary theory and monetarists. The problem is that I don´t agree totally with "market monetarists" on one aspect that trouble me: It seems to me that they think that all the problems are monetary, and they neglect the financial crisis. In short, they say (some of them) that in 2008´s crisis, there was no financial problem, only a monetary one.
I cannot agree. For me it was (and it is now in Europe) a big financial problem, that requires monetary measures, of course. I agree that we need a LLR in Europe, but because the financial crisis.
By the way, I´m searching for a good monetary & financial history since gold standard. I,ve read Friedman´s, Fergurson,s Reinhard´s and so on, but I need urgently one more. Thanks.

26. JP Koning:

At the same time, I'm sure we can all agree that the job of a LOLR is to provide liquidity, not set market prices.

Not sure that I agree. The whole point of a LLR is that the market is mispricing a class of assets, at least temporarily, and that this mispricing has an externality in the payments system.

As to whether central banks are good at LLR activities, I suppose the only way to measure this is to look at their historical losses on such interventions. If they make a profit, on average, then it is likely the case that the market was mispricing assets. (And the Fed did make a profit on its recent interventions, though this could have been sheer luck.)

Mike Sproul:

Well, you could be correct. But we'll just have to take what you say here as your opinion. It would be good to have your opinion represented as a proposition that follows from a given set of assumptions; and then to lay out precisely what these assumptions are.

Luis: If you find that reference, please let me know!

27. I´m reading Bagehot´s book (thanks for the link) and it is quite informative about the BoE history.
But, sorry, I´d like to reformulate my question: Can we subordinate all financial problems in a monetary case? I don´t think so. But I´m not sure.
I mean that, all liquidity scarcity will lead to a financial one; but I can´t say exactly the opposite.
what is a financial problem without liquidity scarcity?
I think that goods markets and financial market are very diferent. are financial markets a black hole in monetary macroeconomics?
Sorry for my persistance.
My doubts arise from the very diferent opinions I read on the euro problem.

28. Bagehot wrote before open market operations, when lending was the primary way for a central bank to increase the supply of (central) bank notes when the demand for them went up in a panic. A case can be made that Bagehot, were he writing today, would say that open market purchases of securities are sufficient to increase the supply of money in a panic. That keeps the central bank out of credit allocation.

29. Give me a break, leave banks alone and you get fraud, which we already see. There is no invisible hand, no free market. Those are mutterings of intellectualism.

Private banking leads toward totalitarian futures. Ask when the capitalists created "Bolshevism" and "Nazism" from the investment houses breasts.

This site needs to grow up.

30. "The whole point of a LLR is that the market is mispricing a class of assets, at least temporarily"

I'm not sure what constitutes a mis-pricing. When the Fed hands markets a free put on liquidity, actors will maximize the value of that put by increasing liquidity transformation bets. At the extreme of the credibility of the Fed's promise, I would argue liquidity transformation bets are massively "mis-priced": that is, their price is purely a function of the Fed's promise. If the Fed does not deliver (as happened with Lehman), there is an immediate and dramatic re-pricing of those bets.

I don't see Fed officials looking at their promises/puts from a dynamic perspective: "If we promise "A", markets will do "B", an the resulting systemic risk "C" will make monetary policy difficult to control."

31. Carolyn Sissiko takes issue with the whole concept of a "safe asset". Speculative bets on any asset should entail some degree of insurance against liquidity and maturity risk. When the Fed convinces actors to virtually eliminate those hedges, it renders asset prices a dangerous artifice.

http://syntheticassets.wordpress.com/2011/12/07/failure-is-the-only-sure-path-to-a-safer-financial-system/

32. Modern LLRs lend money that is not theirs. Creating money out of thin air impoverishes most holders of that currency while rewarding those that have made the biggest mistakes.

33. Anonymous (Dec 9, 2:14PM): If you read my post carefully (and I understand how this might be a challenge for you), you'll see that I never claimed that we "should leave banks alone."

David Pearson: "Mispricing" can be identified in economic theory. But it is not so easy to do in practice. I suppose that you want to argue that all assets are always and everywhere priced correctly? And thanks for the link to Carolyn Sissiko. I have some sympathy for her argument. However, unless she formalizes the main proposition, we will never know under what conditions her claim can be expected to be valid or not. Yes, I am arguing for explicit economic theory.

Anonymous (Dec 11, 1:07PM). In the US, the LLR is the Fed. The Fed was created by an act of Congress in 1913--you know, "the people." What on earth are you talking about "lending money that is not theirs?" Btw, your "thin air" argument is a bit of a red herring; see my post here:
http://andolfatto.blogspot.com/2011/03/out-of-thin-air.html

Let's say there are 10 people on an island. Each has \$10. Now, one of those people prints another \$100. He has enriched himself by robbing everyone else; he has changed the relative value of the existing currency. Let's say he loans the \$100 to the other islanders rather than spending it himself. I suppose that's the difference between counterfeiting and central banking. Prices increase due to the increase in money supply, and the lender collects interest on those loans. In the end, the islanders are poorer; part of their money has ended up as interest paid to the one who printed the money.

35. Anonymous (Dec 12 3:55AM):

If you read it, you did not understand it (judging by your comment above).

If you begin with the premise that a money creator is unnecessary (whether private or public), then fine (I refer you to Debreu for all the economics you will need.)

Money creators issue liabilities out of thin air that are backed by real assets. This is not an act of counterfeiting; it is liquidity provision.

Finally, let's begin with your example and imagine that the person discovers a gold mine. What happens in your economy? Answer: the same thing. Question: is gold created out of thin air? Most gold bugs would say no. Ergo, red herring.

36. Re penalty rate. You write: I am speculating that Bagehot may not have insisted on his "penalty rate" dictum in today's day and age. Or perhaps he would have, but for other reasons? I don't know. I just brought it up for discussion.

Bagehot wrote at the time of the gold standard, i.e. then you have to address the external drain first. However, never in the book is the word "penalty" used, but he speaks about a "very high rate" (i.e. to stem the drain). On floating exchange rate, this should not be such a big deal, therefore you also see many LLR loans given at preferential rates. They will normally be below current market rates, but preferably above "normal" rates, ref. some of the Fed facilities that were self-liquidating. By extending preferential rates, the CB is thus providing the banks with a deliberate funding advantage, that can be used to top up earnings and build capital. Whether this is a subsidy and should be approved by Congress is an altogether different discussion.

37. David,

It strikes me the justification for a penalty rate is very simple, and roughly as set out by Blissex above. But to put it in my own words….

It’s widely accepted by regulators and others that banks should not be the recipients of any special favors not available to other businesses. I.e. banks should not be subsidised and should obey the rules of the free market (which can be harsh).

So if a bank (or any other business) faces insolvency, it has two options. First, declare itself insolvent and perhaps get taken over by a stronger business. Second, go running along to someone with cash to spare with a view to getting a loan: Warren Buffet, the Fed or whoever.

But what’s a fair or free market rate of interest to charge a business which is near insolvency? Obviously a pretty high rate and for the obvious reason that if the business does go insolvent despite the loan, then the lender loses out big time.

That’s why Warren Buffet charged Goldman Sachs 10% for the \$5bn loan. Thus the Fed should have charged about 10% for the \$16trillion it loaned to various banks, not the sweetheart rates it actually seems to have charged.

1. Ralph, I appreciate what you are saying. But...

Your conclusions seem to me to be valid only if one believes that financial markets function perfectly well in all circumstances. I personally do not think this is true. And to the extent it is not true, one can design an appropriate intervention. Of course, we must also ask whether the regulator or government agency responsible for the intervention can be trusted to act properly, but that is another matter.

Take the standard Diamond-Dybvig (1983) model. They demonstrate the circumstances that make demandable debt optimal (in terms of achieving a risk-sharing arrangement that is otherwise not feasible). They also show that if the deposit contract is incomplete (in a well-defined sense that I won't get into here), then there is a possibility of a bank-run equilibrium. Moreover, there is potentially a role for a LOLR. The issue is not about granting "special favors" to banks. It is about designing interventions that help complete missing markets. Of course, this only makes sense if you think some markets are missing.

By the way, the Fed did not lend \$16T to anyone. Where do you get your figures? The Fed's balance sheet is presently about \$4.5T, divided approximately equally between treasury and agency debt.

38. Your above article contains a strong hint to the effect that lender of last resort (LOLR) must be a subsidy of banks, though you don’t actually say that explicitly, far as I can see. If that’s what you’re saying, I agree.

Reason for that “must be a subsidy” point is that where a bank is in trouble, it will already have cobbled together all the collateral it can, and will have borrowed at the going market rate by using that collateral. If the central bank then helps it out some more, the CB must by definition lend at below the market rate (e.g. by overestimating the worth of collateral). Alternatively, the CB lends at a genuine penalty rate, in which case the bank goes bust.

Ergo the whole LOLR idea is a self-contradiction.

Incidentally, Bagehot, as you may know, didn’t really approve of LOLR: in the final chapter of his book he said he disapproved, but thought that the idea was so entrenched that it would be impossible to get rid of.

1. Ralph, the key is in what precisely constitutes "the" market rate. If you believe in the EMH, then it is unambiguous and interventions are subsidies. But if markets don't always work very well, "fair market value" has no meaning and an intervention corrects a distortion.

39. Obviously the “run out of reserves” (i.e. gold) point that may have applied to the Bank of England a century or more ago (and mentioned in the above article) no longer applies. But just because central banks nowadays can produce infinite amounts of reserves at the press of a computer key, that’s not necessarily a good reason for doing so.

I see no reason why money lenders (aka commercial banks) should be treated any different to other businesses. If a non-bank firm, or household can’t do its cash flow projections properly and goes running to a private banks for emergency funds, that bank will take a dim view of the potential borrower and charge some sort of penalty rate. Same should go for banks. And if that means the bank goes bust and shareholders are wiped out, then tough.

As for the idea that private banks can be charged appropriate amounts AFTER a crisis is over (suggested by David Andolfatto above), that strikes me as plain unrealistic. Fed committees are stuffed with private bankers. Are they seriously going go vote to charge themselves a penalty? Moreover (and returning to the above case of a non-bank firm which can’t do its cash flow projections properly), I imagine few banks would lend to such a firm at the normal rate and let the non-bank firm pay off the “penalty” over a number of years.

As for the idea that the country’s basic payments system collapses if too many banks fail, the answer to that is full reserve banking, under which the payments system is separated from lending. Under that system, it’s plain impossible (barring political revolution, large meteor strikes etc) for the payments system to collapse, or for lending entities to collapse.