1 International Finance 1:2, 1998: pp Can there be an International Lender-of-Last-Resort?* Forrest Capie City University Business School, London. Abstract A proper understanding of the term lender-of-last-resort shows that there can be no international version. After outlining the nature of financial crises, the lender-of-last-resort is defined, and its origins traced in the history of thought and in British experience in the nineteenth century. A lender-of-last-resort is what it is by virtue of the fact that it alone provides the ultimate means of payment. There is no international money and so there can be no international lender-of-last-resort. The function of such a lender is to provide the market with liquidity in times of need, and not to rescue individual institutions. Such rescues involve too much moral hazard. International institutions are invariably focused on one customer a country in difficulties and so violate this rule of the lender-of-lastresort. * I thank my colleague Geoffrey Wood for his unquantifiable contribution in discussions on this subject over a long period and for specific comments on this article; and Charles Goodhart for his agreement that I draw on some joint work we did in this area. The responsibility for the views presented here is entirely mine Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA
2 312 Forrest Capie I. Introduction Around the world, from Asia to Russia and beyond, there is considerable financial turmoil. There is widespread talk of financial crises, and there are many suggestions being advanced for their resolution. One frequently suggested remedy is that there should be an international lender-of-last-resort. Kindleberger (1989) devoted a chapter to the International lender of last resort, in his Manias, Panics, and Crashes. A recent suggestion has been made that the Bank for International Settlements could be made an international lender-oflast-resort. And in The Economist of 10 October 1998 consideration was given again to the possibility of the International Monetary Fund (IMF) being the international lender-of-last-resort. This paper is not in any way a proposal for reforming the IMF or making suggestions as to how it can perform the function of a lender-of-last-resort. The argument is rather that a proper understanding of that term shows that there cannot be an international lender-of-last-resort. The IMF or some other body like it may still have a function in the international financial system. However, it is perhaps worth noting that the IMF s rescue of countries in recent times is seen by some as creating the moral hazard which produces further problems of the same kind. This issue of bailout is key in an understanding of the role of the lender-of-last-resort. The paper outlines first the nature of a financial crisis, before defining the lender-of-last-resort and considering who can carry out the function. This is followed by a brief discussion of the evolution of the lender in the history of thought, some domestic British experience and noting differences in Europe. Some consideration is then given to what might be an important element in the story the place anonymity plays in the execution of the role. Finally, if all this is accepted, the conclusion that seems inevitably to follow is that there can be no international lender-of-last-resort. The starting question is: is the banking system fragile or robust? Banks in fractional reserve systems take deposits and make loans, and by doing so multiply the stock of money. Similarly, when they fail, or take steps to reduce their assets, they reduce the stock of money, and in the face of wage and price stickiness that has a deleterious impact on real output. The danger of one bank failure leading to others failing increases the danger of a major collapse in the stock of money, and hence a severe recession in the real economy. Avoiding financial instability and the dangers it carries is therefore a concern. But first, how should we recognize a financial crisis? The most operationally useful definition would seem to be that of Schwartz (1986). A crisis is where there is a threat to a country s money supply. This should be distinguished from a situation in which a major bank or financial institution or other institution fails.
3 Can there be an International Lender-of-Last-Resort? 313 The threat to the money stock can be illustrated by means of the simple money/multiplier model a model whose application has proved powerful over the long historical period for different countries. The broad money supply is equal to the money multiplier times the money base: C 1+ D M = B C + R D D where M is broad money; B is the monetary base; C is the public s currency/deposit ratio; and D R is the banks cash reserve/deposit ratio. D This is simply an accounting framework and does not imply causality. Neither does it matter that central banks did not see themselves as behaving as if they were conscious of this framework. It is simply a useful way of setting out the issue. So, for example, it shows how the public have a role to play in determining the money stock in the way in which they hold cash and deposits. And it shows how the banks have a role to play in the way they hold their cash reserves in relation to deposits. Together these give the money multiplier. The monetary authorities control the monetary base, or it is determined via the balance of payments. In a financial crisis the public withdraw deposits and hold cash. And the banks, as they see the demand for cash rising, try to cope with this by raising their cash reserves. Both of these actions have the effect of reducing the money multiplier, and unless the monetary authorities take counteraction there will be a collapse in the money stock. In these circumstances the monetary authorities need to raise the supply of monetary base sometimes dramatically so. This is the purpose of the lender-of-last-resort. Yet it is an issue that has been the cause of a certain amount of confusion in monetary economics, and monetary and financial history. There is disagreement as to how the role should be defined, and some debate as to how it should operate. There are two principal views on the issue. The first is that it means the rescue of an individual institution; the second that it should mean the rescue of the market as a whole the provision of liquidity to allay widespread panic. It is in the first that the misconception lies, and it is important to dispose of that first. Any commercial bank may, from time to time, extend additional loans to clients who are temporarily illiquid, or even by some accounting standards
4 314 Forrest Capie insolvent. They may do so even when the present expected return from the new loan itself is zero or negative, if the wider effects, for example on their own reputation for commitment to clients, or the knock-on effects of the failure of the first client on other customers, should warrant it. By the same token, a nascent central bank an institution still some way short of maturity as a central bank may rescue some client correspondent bank, just as the commercial bank may support its business customer. But we would not want to describe such occasional, and ad hoc, exercises as involving a conscious assumption of a systematic lender-of-last-resort function. Nor would we want to see a mature central bank rescuing individual banks since there is too much moral hazard involved. No central bank would want to pre-commit itself to giving special support to any individual bank which was running into liquidity problems. Especially with the development of efficient, broad interbank and other short-term money markets, a bank liquidity problem that is not caused by some technical problem is likely itself to be a reflection of some deeper suspicions about solvency. Consequently, an unqualified pre-commitment to provide assistance would involve too much moral hazard. Indeed any individual act of rescue involves a degree of moral hazard. The proper view of the lender-of-last-resort involves the bank declaring its position to the market; what is known today as pre-commitment. This role is quite well defined in the literature on English monetary economics in the nineteenth century; and further, the particular institutional arrangements that evolved in England in the nineteenth century were perhaps close to ideal for its execution. The Bank of England was a fully fledged lender-of-last-resort by the 1870s, coming to the rescue of the market in an appropriate fashion through the buffer of the discount houses (as discussed later). It could be argued by extension that the continental European counterparts did not and could not act in this way until at least the end of the nineteenth century, and in most cases probably not until the beginning of the twentieth century. This had implications for the stability of the respective systems. The role of lender-of-last-resort can be said to appear when the institution accepts a responsibility for the stability of the banking system as a whole, which should override any (residual) concern with its own private profitability. Thus, we would argue that it is the intellectual basis and reasoning of institutions for providing such support, rather than the individual act of rescue of the market itself, that determines whether the institution had become a lender-of-last-resort in fact. But while rescues can be clearly dated, shifts in mental perceptions are harder to date. As Fetter (1978) shows, the Bank of England s Court remained divided and uncertain over this issue at least until after the publication of Lombard Street; and we have less insight into the appropriate date in other countries with early founded government banks.
5 Can there be an International Lender-of-Last-Resort? 315 However, by about 1900, this function was widely accepted as a core function of any newly established central bank. The main points to be made are that the lender should not rescue individuals in distress, but supply liquidity to the market as a whole. It is important to stress that it is the peculiar position of the monopoly note issuer and holder and provider of the ultimate means of payment that allows almost obliges it to behave as the lender-of-last-resort. That is the only institution that can supply without limit (but at an increasing price) the ultimate means of payment. It is the knowledge in the markets that supply cannot run out that serves to assure the market and allay the panic. Who carries out the function? It is mainly central banks, though of course it need not be. Central banks have two main functions. One is macro, the preservation of price stability; the other is micro, the preservation of financial stability. And the two are of course related. It is the latter, though, that really defines central banking. And it soon becomes clear that central banks and lenders-of-last-resort are close to being synonymous. It is in pursuit of its goal of price stability that the central bank seeks to keep a broad monetary target stable and it is that which on occasions obliges it to supply a greater quantity of base money. The institutions that we know as central banks have evolved over a long period and acquired, or developed and extended, their functions according to circumstances and the economic and political environment in which they found themselves. It is worth recalling the essential features of their origin and development. Some like to see the origins lying in the acquisition of the right to monopoly of note issue, and there is a case to be made for this, or at least that it is an important element in the make-up of a central bank. Others have emphasized what is often seen as the key function, the lender-of-last-resort. Goodhart (1988) has drawn attention to the potential conflict of interest that exists if the central bank, the institution set up by government, given the monopoly of its business and a generally privileged position in the monetary system, continues to do a substantial amount of commercial business. The conflict of interest arises in the following way. If the commercial banks get into difficulties there is an incentive for the central bank to allow them to fail, or at least to suffer, and to capture more business for itself. This is the antithesis of the last resort role. Prior to the latter part of the nineteenth century, central banks were generally expected to carry out a commercial banking function; in some cases, in the European countries when they were first established, they offered the only sources of commercial banking services (for example, Scandinavia), and they were often the most important and largest commercial bank in their country. Consequently, the early relationships between central banks and commercial banks were often ones of business rivalry and competition. This adversarial relationship was resolved around the early twentieth century in most cases, with
6 316 Forrest Capie a few exceptions (for example, Australia), by a largely uncodified concordat, whereby, in return for the central bank s withdrawal from commercial banking, the commercial banks voluntarily accepted the central bank s leadership. But difficulty remains in defining central banking. The Bank of England was established in 1694, but at that time there was no concept of central banking. Something close to a modern conception had emerged by the end of the eighteenth century, and Henry Thornton probably regarded the Bank of England as a central bank in a modern sense of the term, albeit recognizing some deficiencies in its behaviour. But there are others who would prefer to date it from 1844 or at least to see the Bank Charter Act 1844 as an important landmark, since that bolstered the Bank s monopoly privileges. For others still it would have to wait until the 1870s when the Bank accepted its function as a lender-of-last-resort and effectively withdrew from any rivalry with the commercial banks. We incline to the last mentioned. We turn here to the issue as it is captured in the writings of the two most distinguished contributors to the subject in the nineteenth century, Henry Thornton and Walter Bagehot. The justification for this is that England industrialized first and became the earliest example of an industrial economy with a modern banking system, and hence the birthplace of monetary economics. II. The Classic Position Henry Thornton has been described as the father of the modern central bank. Thornton s classic monograph Paper Credit (1802) is the source of his principal ideas. Joseph Schumpeter called it the Magna Carta of central banking. The essence of central banking for Thornton is contained in the following quotation: To limit the amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction; in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to afford a slow and cautious extension of it, as the general trade of the kingdom enlarges itself; to allow of some special, though temporary, increase in the event of any extraordinary alarm or difficulty, as the best means of preventing a great demand at home for guineas; and to lean to the side of diminution, in the case of gold going abroad, and of the general exchanges continuing long unfavourable; this seems to be the true policy of the directors of an institution circumstanced like that of the Bank of England. To suffer either the solicitations of merchants, or the wishes of government, to
7 Can there be an International Lender-of-Last-Resort? 317 determine the measure of the bank issues, is unquestionably to adopt a very false principle of conduct. (Thornton 1802, p. 259) This is a remarkably clear statement given its date and the state of development in the money market. It describes the ideal daily operation of a central bank. But how should the lender-of-last-resort behave in a crisis? Thornton acknowledged the danger of the failure of one bank leading to the spread of fear and possibly panic and the failure of many banks a common occurrence in the England he was describing, that of the late eighteenth century when there were hundreds of small banks: If any one bank fails, a general run upon the neighbouring ones is apt to take place, which if not checked in the beginning by a pouring into the circulation a large quantity of gold, leads to very extensive mischief. (Thornton 1802, p. 180) The remedy for such an occasion was for the Bank to provide liquidity: if the Bank of England, in future seasons of alarm, should be disposed to extend its discounts in a greater degree than heretofore, then the threatened calamity may be averted through the generosity of that institution. (Thornton 1802, p. 188) Thornton even allowed that several institutions could fail but that the central bank may nevertheless not feel the need to save them: It is by no means intended to imply, that it would become the Bank of England to relieve every distress which the rashness of country banks may bring upon them: the bank, by doing this, might encourage their improvidence. There seems to be a medium at which a public bank should aim in granting aid to inferior establishments, and which it often must find it 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. (Thornton 1802, p. 188)
8 318 Forrest Capie Thornton s view of the lender-of-last-resort was one that placed the emphasis on responsibility to the market, and not to an individual institution. The central objective is to prevent the collapse of the money stock. This is what we take to be the classic position. Bagehot was the great developer and expounder of these views in the nineteenth century. He first wrote on this subject in 1848 in the first article that he published (Bagehot 1848). He was writing first of all about the previous year s financial crisis and commenting at the same time on the Act of His article is remarkable for one so young (he was only 21 at the time) and is worth quoting at length: The currency argument is this: It is a great defect of a purely metallic circulation that the quantity of it cannot be readily suited to any sudden demand; it takes time to get new supplies of gold and silver, and, in the meantime, a temporary rise in the value of bullion takes place. Now as paper money can be supplied in unlimited quantities, however sudden the demand may be, it does not appear to us that there is any objection on principle of sudden issues of paper money to meet sudden and large extensions of demand. It gives to a purely metallic circulation that greater constancy of purchasing power possessed by articles whose quantity can be quickly suited to demand. It will be evident from what we have said before that this power of issuing notes is one excessively liable to abuse because, as before shown, it may depreciate the currency; and on that account such a power ought only to be lodged in the hands of government It should only be used in rare and exceptional circumstances. But when the fact of a sudden demand is proved, we see no objection, but decided advantage, in introducing this new element into a metallic circulation. (Bagehot 1848, p. 267) That is one of the clearest statements on the need for liquidity and the form its provision should take. The English banking system was continuing to evolve, sometimes in ways that Bagehot did not entirely approve of. He would rather there had been no central bank and that competition prevailed, but accepted that the system that had emerged had to be lived with. Before 1870 there had been no consistency in the behaviour of the Bank of England. Sometimes it came to the rescue of the market and sometimes did not. Sometimes it bailed out insolvent institutions and at other times did not. In the context of these developments Bagehot set out his views first in the pages of The Economist, of which he was editor in the middle decades of the century, and then in Lombard Street (1873). It was in the latter that Bagehot set out what is taken to be his definitive position.
9 Can there be an International Lender-of-Last-Resort? 319 Where in Thornton s time of writing there were no joint stock banks, by 1870, when Bagehot embarked on Lombard Street, there were many such banks, and they were beginning to dominate the system. The risk of panic was clearly increased if a large joint-stock bank collapsed: no cause is more capable of producing a panic, perhaps none is so capable, as the failure of a first-rate joint stock bank in London. Following Thornton, though, the solution was the same: (Bagehot 1873, p. 251) A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. He goes on: (Bagehot 1873, pp ) That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the unsound people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected. The great majority, the majority to be protected, are the sound people, the people who have good security to offer. (Bagehot 1873, p. 188) This brings the emphasis back to the security on offer and thus to the market as a whole. But in addition Bagehot argued that these large joint-stock banks should provide more information about their activities, so that the sound might be separated from the unsound. These two writers, Thornton and Bagehot, provide the classic view of the essence of central banking. The ideal form of the lender-of-last-resort was one in which there should be no individual bailout, but rather an acceptance to discount good quality paper irrespective of where it came from. Some of these quotations cited above are of course open to different interpretation, and especially so since the monetary and banking systems were undergoing continual change. Not surprisingly, there continues to be some disagreement over the precise meaning of the lender-of-last-resort. It is clearly
10 320 Forrest Capie not easy to date the function, as it was something that was groped towards. A central bank in the making could come to the rescue of one of its customers (a bank) who was temporarily illiquid or even insolvent. Our argument is that such a rescue is analogous to the commercial bank rescuing one of its customers simply good business practice. If we were to take this as a measure of the last resort function then the Bank of England became such a lender in the eighteenth century. But as we stressed, no central bank could pre-commit itself to coming to the rescue of any individual bank that was confronted with liquidity problems. That would result in serious moral hazard. A central bank assumes the function of lender-of-last-resort when it accepts responsibility for the banking system as a whole, and that should override any residual concern with its own profitability. It is the appreciation of how they should behave in a crisis, rather than any individual act of rescue, that should date the acceptance of the role. III. The Case of England The history of the Bank of England (the Bank) is quite well known, and may easily be summarized and placed in the context of the framework outlined above. Founded in 1694, it was the government s bank from that date on. Joint-stock banking was prohibited, but a vigorous banking system developed in the next 100 years. The phrase lender-of-last-resort entered the language at the end of the eighteenth century but, as we have argued, the Bank was not such a lender at that time. It did begin to acquire the monopoly of note issue with the 1844 Act, though in effect the monopoly had to wait until the 1870s. It was also in the 1870s that the Bank accepted that its public responsibility greatly outweighed its pursuit of profit, and it became the lender-of-last-resort. There is no explicit statement to this effect, but following the exhortation of Bagehot first in The Economist in the 1860s, and then more persuasively in Lombard Street (1873), it seems the Bank accepted that public responsibility. Its commercial business continued, but was not significant. In the 100 years after 1870 there seems to be ample demonstration that the British financial, and particularly banking, system was enormously stable, and that that stability was due in some good part to the operations of the Bank of England. The value of the currency was maintained, apart from wartime experience, for most of that period. More significantly there were no financial crises in the period. Where crises had been periodic before 1870, there were none after that date. Admittedly that requires a little more elaboration. But following Schwartz s (1986) definition of a financial crisis something that threatens or actually produces a collapse in the money stock seems sensible. There will be occasions when banks, like other firms, fail, but that does not
11 Can there be an International Lender-of-Last-Resort? 321 constitute a financial crisis. Exceptions may be taken to this definition, but it does seem to provide the most useful approach, in that it allows some harder assessment of a crisis, in terms of cash and reserve ratios. There were occasions in this period after 1870 when there was the appearance of crises and some of these have been so described. For example, in 1878 the City of Glasgow Bank failed, and that had some repercussions in the banking sector, even if these were not serious. An examination of the public s currency/deposit ratio shows no rush to cash. Neither did the banks build up or lose their reserve/deposit ratio. The Bank of England did nothing to help, and rightly so, since the Glasgow Bank was corruptly run. The approach is useful again in describing the events of 1890 sometimes called The Baring Crisis and correctly so since there was a crisis for one bank but not for the system. Baring s did indeed fail and was reconstituted. The Bank of England participated in that it organized a lifeboat, but it did not bail out an overstretched bank. In other years when there were crises around the world, and generally transmitted by means of the fixed exchange-rate system, they nevertheless did not appear in Britain is an example. By then, of course, it was accepted in Britain that the Bank knew how to behave, and signs of panic abroad did not spark panic in England. The same is true of the interwar years, when again British banking was enormously stable. There was a crisis in 1931, but it was an exchange-rate crisis. No banks failed, even if there was a little fudging of that issue. And, generally speaking, bank profits were not badly dented. This contrasted starkly with most of the rest of the world, with one or two exceptions such as Canada and The Netherlands. Furthermore, it has been shown that for the years after 1870 the Bank of England acted to avoid panics and did so very successfully (Ogden 1991). Of course there were other factors in the British experience that contributed to stability. The most important was the structure of the banking system. It was increasingly a thoroughly branched system that allowed banks considerable diversification. At least in the years before 1914, this stability did not depend on the cartel, which had barely come into being at that date. Separating the respective contributions of these factors is a task yet to be tackled. Structure may well turn out to have been the more important, but the stabilizing presence of a trusted central bank must have made its own important contribution. Continental European experience was mixed. In almost all European countries there were, from an early date (early according to their industrial development), relatively large joint-stock banks, and they competed with the government s bank. The latter s function was essentially the preservation of the value of the currency metal convertibility. This could conflict with its pursuit of commercial business, and its role as banker to the other banks. As we noted, there were occasions when European banks moved their discount
12 322 Forrest Capie rate in a direction that appeared to be at odds with the preservation of the value of the currency. More research is required on these episodes with a view to ascertaining what pressures were found in the foreign-exchange markets and how these were dealt with. But the main point to make is that there were a number of impediments to the proper functioning of a central bank; impediments that did not disappear in the main, until the twentieth century. IV. Anonymity It is possible that a crucial element in this story is that anonymity is of fundamental importance in the execution of the lender-of-last-resort function. The lender-of-last-resort supplies funds to the market in times of need. It does not supply individual institutions. In its proper form it should not engage in bailing out firms of any kind, be they banks or non-banks. Therefore, if the operation could be carried out where the identity of those seeking funds was not known to the Bank that would be ideal. The mechanism can be thought of as the central bank with a discount window which is of frosted glass, and is raised just a few inches. Representatives of institutions could therefore appear at the window and push through the paper that they wanted discounted. The central banker would return the appropriate amount of cash, reflecting the going rate of interest. The central banker does not know, nor does he care, who is on the other side of the window. He simply discounts good quality paper or lends on the basis of good collateral. In this way institutions holding good quality assets will have no difficulty in getting hold of the funds they need. Institutions with poor quality assets are likely to suffer. In times of panic the interest rate would rise. By something of a happy accident, this was in effect the system that developed in England. At the beginning of the nineteenth century the Bank of England monopoly aroused the ire of the banking community. Such was the antipathy between the Bank of England and the new joint-stock banks that they preferred to keep a distance between each other. Discount brokers emerged who conveniently transacted business between them. These discount brokers gradually acquired the capital base to finance their own portfolios, and by the third quarter of the nineteenth century had developed their modern form of the discount house. When the commercial banks were under pressure in a liquidity squeeze, their first line of defence was to call in their loans to the discount houses, and this in turn sent the discount houses off to the Bank of England where they had special access. If the commercial banks had to cash in bills, they would do this at the discount houses, and the latter would in turn take them to the Bank. In this way the central bank never needed to know where the great bulk of the