A Critique of Bagehot was a Shadow Banker: Introduction

A paper titled Bagehot was a Shadow Banker came to my attention last month. While I know that the authors, Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson are very smart and am confident that they are also well-intentioned, none of them has engaged in the careful study of British monetary history that would allow them to support the claim made in the title of their paper. As a result, their conclusions are built on a flawed understanding of the nature of both 19th century and, I would argue, modern finance.

The authors of Bagehot was a Shadow Banker argue that the shadow banking system, in which long-term assets are funded using short-term commercial paper and repurchase agreements, should be stabilized by price supports provided by the central bank to the long-term assets. This role for the central bank is dubbed the “dealer of last resort.” Their point is that this role is a natural extension of the “lender of last resort” role of the Bank of England that Bagehot famously described. In the 19th c. the Bank of England purchased on a recourse basis (i.e. discounted) only short-term assets. Typical assets matured within three months, though it is not unlikely that longer paper of one or even two years may have been discounted in the later years of the century. For very select accounts, the Bank also advanced funds on a temporary basis (similar to a modern repurchase agreement) against long-term government bonds and borrower-selected “parcels” of short-term assets.[1]

My goal in this paper is to demonstrate that Bagehot was a Shadow Banker (i) misunderstands the nature of the 19th century English monetary system and the means by which it supported the economic growth of England at the time; (ii) ignores crucial characteristics of the 19th century monetary system, such as the personal liability faced by bankers – or the capital calls faced by bank shareholders – when banks circulated assets that went bad; and (iii) fails to understand that the term “lender of last resort” is a direct reference to the fact that bank solvency is endogenous and actively determined by the central bank, not an exogenous characteristic of an individual bank. Because the paper is built on the pretense that the illiquidity-insolvency distinction is a property of individual banks, rather than a determination made by the central bank, the paper conceals the fact that any “dealer of last resort” will have the task of making the final determination of the “true” value of the assets.

The movement from a lender of last resort to a dealer of last resort is, therefore, a significant change, because by purchasing “prime” assets at a specific price the dealer of last resort removes from the selling bank the obligation of guaranteeing the value of the assets. Instead of indirectly supporting the prices of assets (which indeed has always been a role of the lender of last resort), the dealer of last resort directly supports asset prices and eliminates the measure of market pricing of assets that has always existed under lender of last resort systems. A bank that knows an asset is bad and sells it at an inflated value to a lender of last resort will have to come up with the difference in value in the future or the bank will fail. This is a strong disincentive to passing bad assets, particularly in 19th c. financial systems where bankers’ personal assets’ were on the line. It is precisely this disincentive to passing bad assets off on the central bank that the authors apparently wish to eliminate by establishing a dealer of last resort – and that they claim is a policy that Bagehot would have supported.

The distinctions between the 19th c. environment and the modern environment are very important, and are neither addressed – nor indeed even acknowledged – by Bagehot was a Shadow Banker. The Bank of England determined which assets were worthy of being discounted in an environment where almost no bad assets circulated: the assets eligible for discount were of high quality, not only because they had very short maturities and thus limited exposure to unexpected events, but also because the bankers who circulated the assets put their personal wealth at risk by accepting them and then discounting them.

Thus, the claim that “Bagehot would have recognized [the dealer of last resort] as a fully legitimate support of the prime bill market” is overstated. Bagehot would not have recognized the finance of assets of more than a few years maturity as the business of any banker, much less the business of a central banker. Bagehot would have been horrified at the “sloppy, or even fraudulent, underwriting” that led to the 2007-08 crisis, (at 13) and might well have recommended that the government disentangle itself from such a monetary system entirely.[2]

I will address first the nature of the 19th c. monetary system and the means by which it supported economic growth in the understanding of 19th c. theorists. Next I will address the quality of the assets that circulated as money in the 19th c. and the importance of the personal liability of bankers to the quality of the assets. Third, I will address the origins of the term “lender of last resort” and the emphasis the term places on the endogeneity of the concept of solvency. Finally, I will discuss whether the claim that a “market-based credit system” exists in modern markets is well-founded.


[1] Marc Flandreau and Stefano Ugolini, Where it all began: lending of last resort and the Bank of England during the Overend-Gurney panic of 1866, Norges Bank Working Paper 2011-3 at 7, 31 (2011).

[2] “So long as the security of the Money Market is not entirely to be relied on, the Government of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.” Lombard Street, IV.4.

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