Origins
The concept of a “lender of last resort” was codified by Walter Bagehot in his 1873 classic, Lombard Street. Bagehot analyzed how the Bank of England had evolved from a simple commercial bank into the guardian of the British financial system. He identified that during a crisis, the typical instinct to hoard cash only exacerbates the panic, creating a self-fulfilling prophecy of failure.
The problem this function solves is the “neuralgia” of a panic, where depositors or creditors suddenly withdraw funding from healthy institutions out of fear. Before this role was formally centralized in the Federal Reserve, it was performed privately by J.P. Morgan during the Panic of 1907, where he decided which institutions were “the place to stop the trouble.”
Structure & Function
The lender of last resort operates according to what became known as “Bagehot’s Rules”: during a crisis, the central bank should lend freely and boldly, at high rates of interest, on good collateral. The high interest rate ensures that only truly desperate borrowers seek emergency funds, while the requirement for good collateral protects the central bank from losses.
The mechanism distinguishes between illiquidity and insolvency. An illiquid bank has good assets but cannot sell them quickly enough to meet deposit withdrawals; it should be saved. An insolvent bank has bad assets that are worth less than its liabilities; it should be allowed to fail. In practice, this distinction is difficult to make in the heat of a crisis, and lenders of last resort often end up supporting institutions whose solvency is questionable.
Historical Significance
The lender of last resort function has become central to modern financial architecture. Every major central bank now stands ready to provide emergency liquidity during crises. The Federal Reserve’s response to the 2008 financial crisis—providing trillions in emergency lending through various facilities—represented the most extensive application of this function in history.
However, the doctrine has created persistent tensions. By promising to rescue banks during panics, the lender of last resort creates moral hazard—banks take excessive risks knowing they will be bailed out. The expansion of the function from deposit-taking banks to investment banks (Bear Stearns), insurance companies (AIG), and even money market funds has raised questions about its proper limits.
Key Developments
- 1825: Bank of England begins recognizing its responsibility to support the banking system during crises.
- 1866: The Overend, Gurney crisis; Bank of England acts decisively as lender of last resort.
- 1873: Walter Bagehot publishes Lombard Street, codifying the principles of last-resort lending.
- 1907: J.P. Morgan acts as private lender of last resort during the Panic of 1907.
- 1913: Creation of the Federal Reserve institutionalizes the lender of last resort function in the U.S.
- 1930s: The Federal Reserve’s failure to act aggressively as lender of last resort contributes to the Great Depression.
- 1998: Federal Reserve coordinates private rescue of Long-Term Capital Management (LTCM).
- 2008 (March): Federal Reserve provides emergency lending to facilitate Bear Stearns rescue.
- 2008 (September): Federal Reserve provides unprecedented emergency lending to AIG.
- 2008–2009: Federal Reserve creates multiple emergency lending facilities, expanding the lender of last resort function beyond traditional banks.
- 2010: Dodd-Frank Act attempts to limit Federal Reserve emergency lending authority.
- 2020: Federal Reserve again expands emergency lending during COVID-19 crisis.