5. ConclusionOne hundred and thirty

5. Conclusion
One hundred and thirty-five years ago, Walter
Bagehot wrote that to stay a banking panic,
the bank supplying reserves i) “must advance freely and vigorously to the public,” ii) “that
these loans should only be made at a very high rate of interest” and iii) “at this rate these
advances should be made on all good banking securities, and as largely as the public ask for
them.” (1873, pgs. 74-75). From this central banks derived the theory of the LOLR. But
Bagehot lived in a different world. Not only were there no automobiles, airplanes, or
computers, there were virtually no central banks. In the late 19
th
century there were fewer
than 20, while today there are more than 170. Since central banks are very much a 20
th
century creation, so it is natural to ask whether a 19
th
century doctrine still applies.
In this paper we have argued that Bagehot’s view of the lender of last resort requires
refinement. As the financial system has gained in complexity, so have all facets of the role of
central banks. Following the trail blazed by Bagehot, we began by noting that central bank
intervention is designed to alleviate liquidity shortages. We then went on to identify three
types of such shortages that can occur in
the modern financial system: i) a shortage of
central bank liquidity; ii) a chronic shortage of fu
nding liquidity at a specific institution; and iii)
a systemic shortage of funding and market liqui
dity. This was followed up by a discussion of
how it is that central banks can use their tools to address each of these.
Our analysis leads us to conclude that the appropriate principles for central banks’ LOLR
support must be conditioned on the particular type of liquidity shortage that is taking place.
When confronted with a simple shortage of c
entral bank liquidity, fo
r example, Bagehot’s
rules apply. By contrast, a systemic event almo
st surely requires lending at an effectively
subsidized rate compared to the market rate while taking collateral of suspect quality.
In the same way, any discussion of communication policy in the potential future application of
LOLR policy, such as the desirability of constructive ambiguity, must be linked to a specific
type of liquidity shortage. So, for example, while
ambiguity of access to central bank liquidity
may be an important countervailing force against moral hazard in situations of chronic
institution-specific liquidity shortages, it is
likely to be counterproductive when it comes to
dealing with general shortages of central bank liquidity or in the midst of a systemic crisis.
In terms of the debate outlined earlier on the appropriate form of LOLR lending, the current
crisis has made it abundantly clear that the argument that only open market operations are
needed to meet the liquidity needs of manifest
ly sound banks is flawed since money markets
can themselves fail to function properly. This is even more so in light of recent developments
in the financial system. The interaction of funding liquidity with market liquidity has created
difficult challenges for central banks. Runs must be envisaged in markets and not just banks,
which given mark-to-market accounting, leads
to threats to the liquidity and solvency of
banks via changes in market prices.
Finally, when confronted with a systemic liquidity crises, the experience so far point towards
some useful features that central banks are likely to require of their operational frameworks.
These include: i) flexibility; ii) far reaching coun
terparties; iii) wide range of eligible collateral;
iv) clear communication of intended actions; v) close coordination with fiscal authority; vi)
close cooperation with other central banks.