Lenders of Last Resort have duties in normal times too

I have a paper forthcoming in the Financial History Review that studies the role played by the Bank of England in the London money market at the turn of the 20th century. The Bank of England in this period is, of course, the archetype of a lender of last resort, so its activities shed light on what precisely it is that a lender of last resort does.

The most important implication of my study is that the standard understanding of what a lender of last resort does gets the Bank’s role precisely backwards. It is often claimed that the way that a lender of last resort functions is to make assets safe by standing ready to lend against them.

My study of the Bank of England makes it clear, however, that the duties of a lender of last resort go far beyond simply lending against assets to make them safe. What the Bank of England was doing was monitoring the whole of the money market, including the balance sheets of the principal banks that guaranteed the value of money market assets, to ensure that the assets that the Bank was engaged to support were of such high quality that it would be a good business decision for the Bank to support them.

In short, a lender of last resort does not just function in a crisis. A lender of last resort plays a crucial role in normal times of ensuring that the quality of assets that are eligible for last resort lending have an extremely low risk of default. This function of the central bank was known as “qualitative control” (although of course quantitative measures were used to predict when quality was in decline).

Overall, if we take the Bank of England as our model of a lender of last resort, then we must recognize that that the duty of such a lender is not just to lend, but also to constantly monitor the money market and limit the assets that trade on the money market to those that are of such high quality that when they are brought to the central bank in a crisis, it will be a good business decision for the bank to support them.

A central bank that fails to exercise this kind of control over the money market, can expect in a crisis to be forced, as the Fed was in 2008, to support the value of all kinds of assets that it does not have the capacity to value itself.

Note: the forthcoming paper is a new and much improved version of this paper.

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