A note on the lender of last resort

“They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.” Walter Bagehot, Lombard Street (1873)                                                           

“Bagehot’s famous dictum, in Lombard Street, was that, to avert panic, central banks should lend early and freely (i.e. without limit) to solvent firms, against good collateral, and at ‘high rates.’”   Paul Tucker (2009) (bold added)                                                                                                                 


With the publication of former Treasury Secretary Timothy Geithner’s book Stress Test comes a reconsideration of the many aspects of government intervention during the years of the financial crisis. Should banks have been nationalized?  Should the fiscal stimulus have been larger? Should underwater households have received mortgage assistance? 

All of these are important questions, as are many others.  Among them is whether the Federal Reserve should have provided a loan to Lehman Brothers to keep it from failing. A related issue is whether it should have provided support, as it did, to nonbanks Bear Stearns and AIG.

In responding to queries about the Federal Reserve’s actions on the fateful Lehman weekend in mid-September 2008, various officials noted that the law does not allow the Federal Reserve to lend to an insolvent institution. As we reconsider the role of central bank lending, this is one principle, dating back to Walter Bagehot in the 19th century, that it is important to understand and maintain.

There are three big reasons that a central bank should not lend to a bankrupt institution.  The first is that, by lending secured to an insolvent commercial bank, the central bank further subordinates bond holders.  It does this both by allowing short-term depositors to run and also by inserting itself ahead of others in the queue for claiming repayment when failure inevitably comes. These actions pick winners and losers. In democracies, such choices are typically the prerogative of elected officials, not central bankers.

Second, lending to an insolvent institution by itself does not put an end to its fragility. Ultimately, the institution must be liquidated or re-capitalized. Postponing this resolution is usually costly. The capital hole itself tends to widen when an impaired institution freezes up in a financial crisis. More broadly, when resolution is delayed, the resulting mix of uncertainty and poor incentives damages both the financial system and economy.

Third, when people find out that the central bank is willing to lend to insolvent banks – and they will find out – then any bank that borrows will be suspected of being bankrupt. The resulting stigma will impair the useful function of the lender of last resort as a lender to solvent, but illiquid banks. In the end, only those that are bankrupt will borrow and the central bank’s lending facility will become useless.

So, the problem in September 2008 was not that the Federal Reserve refused to lend to Lehman.  Taking officials at their word that Lehman was bankrupt, they were legally precluded from doing so. [The Lehman bankruptcy procedure is ongoing, but The Wall Street Journal (“Lehman to Dole Out Additional $17.9 Billion to Creditors,” March 27, 2014) reports that creditors will receive 26.9 cents on the dollar.] Even if it had been legal, the Fed should not have lent to an insolvent firm. 

The real problem in 2008 was that there was no resolution regime in place that would allow Lehman or other big intermediaries to fail without disrupting the entire global financial system. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has created a new resolution mechanism for the largest U.S. intermediaries. However, that regime (including the FDIC’s new “single-point-of-entry” implementation strategy) remains untested, and would still face an extraordinary challenge if one or more globally active banks were to fail.

Importantly, Dodd-Frank also narrowed the legal form of recipients eligible for Fed discount loans, contrary to the broad latitude suggested by Bagehot. Back in 2008, the Fed could lend “in unusual and exigent circumstances” to any “individual, partnership or corporation.” Today, the Fed no longer has the authority to lend to an individual nonbank (like AIG, Bear, or Lehman) outside of a “program or facility with broad-based eligibility” (think “Term Auction Facility”). Post Dodd-Frank, the discount window is for banks only. Others will have to seek liquidity elsewhere, even if they are solvent.