III. Bank Solvency is Determined by the Lender of Last Resort
This is Part III of a lengthy critique of Bagehot was a Shadow Banker, written by Perry Mehrling, Zoltan Pozsar, James Sweeney and Daniel Neilson. In Bagehot was a Shadow Banker, the authors argue that dealers on financial market need a backstop from the central bank and that “central banks have the power, and the responsibility, to support these markets both in times of crisis and in normal times. That support however must be confined strictly to matters of liquidity. Matters of solvency are for other balance sheets with the capital resources to handle them.” This conclusion is mind-boggling to those who know the history of the concept “lender of last resort.” The whole point of a lender of last resort is that this is the entity that makes the determination as to whether a financial institution is solvent or not. Solvent institutions are given liquidity support and allowed to live, and insolvent institutions are not.
The term “lender of last resort” has its origins in Francis Baring’s Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.
In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain.
For this reason, it is unsurprising that Flandreau and Ugolini find that the Bank of England limited moral hazard “by not lending ‘anonymously’,” but instead by carefully tracking both its exposure to each individual acceptor and discounter, and the degree to which each acceptor and discounter was extending – or overextending – credit to others. This monitoring was accompanied by the rarely-used, but ever-present, threat of refusing liquidity to the acceptor or discounter by refusing to discount its paper. What Flandreau and Ugolini do not appear to realize is that similar policies were in place a full century before the time period that they study.
In 1772, the Bank of England stopped discounting the bills of the Ayr Bank (including accepted bills), because the number of bills the Ayr Bank was circulating was large enough that it was almost certain that the bills were not all “real” — that is, created only through the process of actual commercial trade. At the time a letter was published in the London Chronicle stating:
You will find that the only cause of such bills as are good at bottom being refused by private bankers in London, is because the Bank of England will not discount them, and on that account such bankers cannot turn them into cash till due, be their necessity ever so great. For this and other obvious reasons, you will find it impossible to carry on your business as a banking company independent of the Bank of England, that being the great source of the British funds, and credit without whose countenance and occasional aid, no banker, nor merchant even in London can do business with safety and profit. (Sept. 15-17, 1772)
The author of this letter makes it clear that a bank was solvent because the Bank of England stood behind it, and was insolvent if the Bank did not. In short, after the failure of the Ayr Bank contemporary bankers understood that solvency was not an exogenous state, but for each bank depended upon the on-going support of the Bank of England.
In 1802, thirty years after the Ayr Bank collapse, Henry Thornton explained that one of the fundamental roles played by the Bank of England was to limit the amount of credit available to both London banks and country banks.
While the transactions of the surrounding traders are thus subject to the view of the country banks, those of the country banks themselves come under the eye of their respective correspondents, the London bankers; and, in some measure, likewise, of the Bank of England. The Bank of England restricts, according to its discretion, the credit given to the London banker. Thus a system of checks is established, which, though certainly very imperfect, answers many important purposes, and, in particular, opposes many impediments to wild speculation. (at 176)
There seems to be a medium at which a public bank should aim in granting aid to inferior establishments, and which it must often find very difficult to be observed. The relief should neither be so prompt and liberal as to exempt those who misconduct their business from all the natural consequences of their fault, nor so scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or even ruinous may be their state. (at 188).
Thus, Thornton focuses attention on the key policy question faced by the Bank of England: When to withdraw its support from a bank or bill broker that is undermining the quality of origination practices in the market, despite the possibility that the decision could have an adverse effect on the broader market. This illustrates that the Bank of England’s decision in 1866 not to support Overend, Gurney & Co. was made in the context of a long history of similar decisions, which had as their purpose promoting the quality of the London money market.
The authors of Bagehot was a Shadow Banker view the solvency of a bank as a state that exists independent of the central bank, and they view government bailouts to protect bank solvency as a necessary corollary to lender of last resort activities “in any real world crisis.” They explain:
the maintained assumption of the present paper that the financial crisis is entirely a matter of liquidity and not at all a matter of solvency. Under this strong (and admittedly unrealistic) assumption, no additional capital resources are needed to address the crisis because there are no fundamental losses to be absorbed, only temporary price distortions to be capped. In any real world crisis, of course, there are both liquidity and solvency elements at play, so liquidity backstop is insufficient. Just so, in the US crisis, there was the Treasury standing in the wings to provide capital as needed (e.g. TARP). In this paper we have abstracted from such matters in order to draw attention to the liquidity dimension, which remains largely unappreciated. (At 14-15).
Recall, however, that, as was discussed in Part II, careful analysis of the data by economic historians demonstrates that: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.” Thus, in 19th c. England the assumption that a crisis was entirely a matter of liquidity was not an unrealistic assumption at all, since the owners of the bank were personally liable for the circulation of bad debt. And, in practice, all losses were borne by the bankers.
Because the 19th British financial crises were true liquidity crises, the banks from which the Bank of England withdrew support could have continued in business certainly over the short-term and possibly for years in the absence of the denial of liquidity by the Bank of England. For this reason, in 19th c. Britain the lender of last resort’s determination that a bank was not worthy of its support was the direct cause of the bank’s failure. In short, the term “lender of last resort” refers to the central bank’s role of protecting the financial system by denying liquidity to those firms that don’t meet the standards of the central bank.
Bagehot’s prescription for the conduct of a central bank in a crisis is usually framed affirmatively: A central bank must lend freely at high rates on all good collateral. In the 19th c., however, “good” collateral was determined principally by the quality of the acceptance and of the discounter. Thus, Bagehot understood his prescription to be entirely consistent with the Bank’s rejection of paper on which one of the required guarantees was given by Overend, Gurney & Co. And Bagehot’s prescription is also entirely consistent with the disciplinary role played by the lender of last resort in denying liquidity to firms that are so badly run that they can’t give good security as a discounter on their collateral, or in other words be trusted to honor their obligations.
When one understands that the proper exercise of the power of the lender of last resort includes not only supporting the financial system through liquidity crises, but also the careful culling of financial firms to protect the monetary system from badly run firms and the circulation of poor quality assets in the money supply, one realizes that more attention should be paid in the modern literature to the dangers of using liquidity support to keep poorly run firms alive. Instead of assuming, as the authors of Bagehot was a Shadow Banker do, that liquidity crises are always accompanied by solvency crises that must be addressed by government bailouts, it is important to realize that the pre-eminent model of a lender of last resort developed in an environment where there were no bailouts.
Therefore, it seems likely that need for bailouts that is common to so many recent crises may reflect the failure on the part of the central banks to protect the money supply by refusing liquidity support to those firms which are so poorly managed that they are introducing bad assets into the money supply. Indeed, Bagehot warned explicitly that government support of a “bad bank” can have extremely adverse effects on the financial system, because such support “is the surest mode of preventing the establishment of a future good bank.”
This analysis of the term “lender of last resort” allows us to reevaluate the authors’ call for the central bank to act as a “dealer of last resort,” whose job is to put a floor on the price not only of prime securities, but also of non-prime securities by accepting the latter as collateral. But just as the lender of last resort has the duty of determining which banks are well enough managed to merit liquidity support, so the dealer of last resort would have the duty of determining which assets are of a quality that merits price support. Note that this is a determination of asset quality, and thus broad categories of acceptable assets cannot substitute for a review of the bank-specific origination and servicing practices that will determine the true quality of the asset. In short, asking the central bank to act as a “dealer of last resort” is asking it – in the midst of a crisis – to review the underwriting of the loans created by the banking system.
One way to avoid this problem is for the central bank to limit the class of assets on which it lends to those assets that are of high quality, and thus easy to price. But that, of course, is precisely what a traditional lender of last resort does – and it is precisely this protection that the proposed “dealer of last resort” seeks to eliminate. Another way to avoid this problem is to monitor the banks themselves and require that they provide a guarantee of the value of any assets that are aggregated by the bank to be used as collateral for a loan from the central bank. Once again, however, this is a very traditional means by which lenders of last resort have long expanded their lending quickly to the most trusted banks in crises. Perhaps the authors in their proposal for a dealer of last resort seek to expand this ability for banks to package and value their own collateral so that it is more generally available. If so, the problem of moral hazard that is created by this system needs to be addressed, since one would expect the weakest banks to use such a lending facility to gamble for redemption.
My reading of the authors’ proposal for a dealer of last resort, however, is that the authors assume that the central bank has the ability to determine on an asset-by-asset basis the appropriate level for price support. Thus, the authors seem to believe that the central bank will be able to intuit the correct level of price support for the non-prime assets of the banking system without re-underwriting the loans to distinguish which are likely to be performing in the future and which are not. It would be helpful if the authors explained the mechanism by which the central bank is to perform the pricing aspect of its role as dealer of last resort.
 Flandreau and Ugolini, at 23 (emphasis in original).
 Vincent Bignon, Marc Flandreau, & Stefano Ugolini, Bagehot for beginners: the making of lender-of-last-resort operations in the mid-nineteenth century, 65 Econ. Hist. Rev. 580, 602 (2012).
 Bagehot, Lombard Street, at IV.4 (“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.”)
 Flandreau and Ugolini, at 7.