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Introduction
Since the end of 2009 the European Union has been facing an emergency situation.
Following the outbreak of the Greek Debt crisis, fears that it will rapidly evolve into a
Eurozone debt crisis developed among investors fostered by a wave of downgrades by
credit rating agencies.
The origin of the debt problem varied across countries. In nations like Greece and
Portugal, unsustainable public sector wage and pension commitments drove the debt
to unsustainable levels; in Ireland and Spain, private debts arising from a property
bubble were transferred to sovereign debt as a result of banks’ bailouts.
Although investors’ concerns might well be rooted into fundamentals, it is worth
noting that States outside the Eurozone with an analogous – and in some cases worse
– debt situation, like the United Kingdom, Japan and the United States were not hit by
the market distrust.
Two of the most suggestive explanations of this different market sentiment are put
forth by De Grauwe (2011) and Wyplosz (2012).
The first argues that the structure of the Eurozone as a monetary union without a
common fiscal system contributed to the crisis and harmed the ability of European
leaders to respond; Euro area States cannot control the currency in which their debt is
denominated, and are de facto downgraded to the status of emerging economies,
lacking the possibility of providing liquidity to avoid default in case of a loss of
confidence by the market.
The second – but De Grauwe too – denounces a peculiar difference between the
Eurozone and the other countries: the absence of a lender of last resort; an authority
with potentially unlimited liquidity which stands guarantor for the borrowers with the
ultimate intent of avoiding a collapse of the financial system.
So far, the European Central Bank has refused this role and this thesis focuses on the
possibility to become such a lender in the future.
In particular, this dissertation tries to provide all the instruments for a deep and clear
analysis of the theoretical assumptions and the practical implications of the role of
lender of last resort.
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The work is divided in three parts.
Chapter 1 is about the concept of lender of last resort itself: definition and function,
historical background and all the interactions in the economic contest, supported by
three mathematical models which analytically describe how bank runs occur, the
liquidity provision and bailout mechanisms and the effects of contagion and moral
hazard on the central bank’s behavior. The aim is to provide a solid knowledge of the
topic before examining the practical examples. It is suitable for both the curious reader
who is searching for information on what he daily reads on newspapers or websites
and the researcher who is willing to find an information aggregator both from a
theoretical and a mathematical point of view.
The second chapter focuses on the European Central Bank; after an introduction on its
functions to better understand its real operating range, the ECB’s response to the crisis
is assessed through the list and the explanation of their measures. A particular
attention is reserved to the central debate for this dissertation: should the ECB
become a lender of last resort? Which are the pros and cons of such a change in the
central bank’s policy?
It is shown that European nations implemented a series of financial support measures
such as the European Financial Stability Facility and European Stability Mechanism and
the ECB did its part by lowering interest rates and providing cheap loans to maintain
money flows between European banks, but these measures have proven insufficient to
restore the markets’ confidence and more structural changes are required.
The third and final chapter provides an important benchmark to make the assessment
complete. The Federal Reserve has made its unlimited liquidity available for bailouts,
asset purchases and supporting specific monetary markets which suddenly were not
able to reimburse money any more. In other words the Fed represents the most
striking case of lender of last resort, although not the only one. This section contains a
full report on the US central bank’s effort to put the crisis to an end, including a time
series analysis of one of the most famous and used tools: quantitative easing.
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The Federal Reserve’s effort seems to have been effective on lowering longer-term
Treasury securities’ yields making the United States’ sovereign debt more sustainable,
but benefits on the real economy are far less visible.
All the concepts are picked up in the conclusion for the final considerations.
The author’s wish is to have written a useful reference which can help the reader
orientate in the confusion surrounding one of the most important themes of our times,
what could be not only a switch in the ECB’s priorities, but also a change in the political
equilibria among the Member States and, above all, the European people.
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1- The lender of last resort
1.1 A good father?
Like a parent’s unconditioned support to his son, a financial institution acts as lender
of last resort if it’s willing to extend credit when no one else is.
It serves as a stopgap to prevent widespread panic withdrawal, bank run and
otherwise avoid disruption in productive credit to the entire economy caused by the
collapse of one or many institutions.
Borrowing from the lender of last resort by commercial banks is usually not done
except in times of crisis, otherwise it could indicate that the institution in question has
taken on too much risk or is somehow experiencing financial difficulties; by the way
the term “last resort” is pretty self-explanatory about the event’s uniqueness.
Unfortunately, the crisis we have been living from 5 years – and still going – is exactly
the case.
Decades of deregulation in the name of liberalism and a systemic abuse of
securitization have been the main ingredients for the creation of a giant toxic bomb
that, once detonated, made financial markets almost collapse under an unstoppable
chain of worldwide panic and assets selling-off.
Securitization is the process of taking an illiquid asset and transforming it into a
security. A typical and infamous example is a mortgage-backed security, or MBS;
financial companies like investment banks or public institutions use a mortgage pool as
collateral for security issuing.
The brand new titles are sold to investors in the secondary market and constant cash
flows are secured as long as borrowers pay their mortgage installments.
This game seemed to make everybody happy. Banks took cash out of illiquid assets and
transferred insolvency risk to a third party, investors had new financial instruments to
gain from and above all people could buy houses much more easily.
That’s because securitization markets reached huge, inflated values and took the form
of an economic bubble which would have ignited the biggest financial crisis ever.
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As the risk that borrowers couldn’t repay their debt was not a problem of theirs any
more, banks did not have an incentive to screen mortgage subscribers like before, and
credit was granted even to people it shouldn’t have been allowed to. When this kind of
debtors stopped paying, MBS collateral faded and so did their yields.
Lots of Investors began selling them contemporaneously and all of a sudden banks
found themselves in the situation they tried to avoid through securitization: illiquidity.
The eye of the storm was located in the United States, but 50% of these “sausage
titles”
1
were sold to foreign investors, making sure that whenever the dam had given
way, everybody would have been in trouble.
The result is the plague we are still suffering for; stock prices fell due to herd behavior
and financial globalization and the banking system almost collapsed; as banks feed real
economy by giving firms credit, the liquid hemorrhage resulted in a serious credit
crunch which killed growth and affected all the economic fundamentals.
No one was available to give credit, even among the interbank circuit, and Central
banks were forced to act as lenders of last resort in order to prevent that ATMs all over
the world could stop paying cash out.
This hasn’t been the first time they have played the role of the “good father”. To be
precise, it was the norm during the postwar era, and it wasn’t free.
Banks had to pay for their errors by sacrificing some of their autonomy to avoid a
problem called moral hazard.
In the famous movie Wall Street: Money Never Sleeps the antihero Gordon Gekko says
“Moral hazard is when they take your money and then are not responsible for what
they do with it.” In fact one of the main reasons we all were to return to barter was
that banks had the tendency to take undue risks confident that governments would
help them in case of trouble, like a son doing whatever he wants with daddy’s car
because he knows he wouldn’t pay in case of an accident.
Many steps have been made in order to limit bank crises and suppress reckless
behaviors; the most important example is represented by the Basel Committee on
Banking Supervision.
1
Roubini (2010)
10
This worldwide banking supervisor was established in 1974 by the G-10, it frames
guidelines and standards to improve the system’s stability and its efforts resulted in
three “accords”, the last one having taken effect in 2011.
Basel III takes the legacy of the previous two and is basically a set of rules and
minimum capital requirements which should reduce the risk of a liquidity crunch and
mitigate the potentially lethal effects of maturity mismatches in banks’ balances.
As crises have been unfortunately common in economic history, there are much less
recent measures which need to be considered.
The 1933 Glass–Steagall Act – the American Congress’ answer to the Great Depression
of 1929 – is at the top of the list. It created the Federal Deposit Insurance Corporation
and imposed the separation between commercial and investment banking because
integrated financial services firms were accused of having played a significant role in
the collapse of the banking system.
The act was abolished in 1999 after a long debate on whether it was still justified after
the market developments, but economists like Kuttner, Stiglitz and Weissmann have
linked this repeal to the late 2000s’ financial crisis, claiming that banks were once
again allowed to use depositors’ money to make highly speculative investments.
Although they are probably right, this is only a part of a worldwide historical trend of
deregulation and financial innovation. Over-the-counter credit default swaps reached
a 2008 value of $60 trillion and leverage ratios massively increased after the five
biggest US banks lobbied the Securities and Exchange Commission (SEC) to persuade it
to loosen rules that restricted the amount of debt their brokerage units could assume.
Sons were enabled to make mistakes again, and they did.
During the Great Depression the Federal Reserve, under all the presidencies that
followed one another, did not lend anything to banks in financial straits and did not
pursue any expansionary monetary policy. The money supply contracted, leading to a
liquidity and credit crunch which affected the whole economy.
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Lots of economists, including Friedman, described these actions as harmful, and the
current Fed Chairman Ben Bernanke thanked him for highlighting the past mistakes so
that they wouldn’t be repeated.
2
As a matter of fact the response to the 2008 financial crisis was the exact opposite. The
U.S. central bank acted as lender of last resort and pumped a huge amount of liquidity
into the markets.
It was not alone. In November 2009 the Bank of England revealed it lent £ 69bn to the
giants RBS and HBOS in order to prevent their imminent collapse
3
, but failed to avoid
Northern Rock’s bank run and following nationalization.
The Bank of Japan had to face a persistent deflation problem and used some typical
LOLR instruments like quantitative easing, while the International Monetary Fund has
directly lent to States, above all to Greece – over € 480bn estimated –
4
.
Europe is a separate case. Even if the European Central bank has adopted several
measures to cope with the crisis, it can’t technically be considered a lender of last
resort. All these topics will be deepened later on.
1.2 Literature and Historical Background
1.2.1 Bagehot & Thornton, the fathers of the Classical Theory
The current financial crisis, although terribly serious, is only the last of a long series.
The most dramatic nineteenth-century global fallout may have occurred in 1873, when
lots of speculative investments in railroads in the United States and Latin America
made European stock markets implode, leading the investors to liquidate overseas
assets.
Bank runs started and several banks and nonfinancial firms failed.
At the apex of the panic the Economist editor Walter Bagehot wrote: “The doors of the
most respectable banking houses were besieged… and throngs heaving and tumbling
about Lombard Street (the Wall Street of England, Ed.) made that narrow thoroughfare
2
Kupelian (2008)
3
Conway, Monaghan (2009)
4
Wikipedia
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impassable”.
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He also suggested the temporary suspension of Peel’s Act, allowing the
Bank of England to print money at will.
Sometime later, with his book Lombard Street: A Description of the Money Market, he
became one of the first writers to state that a central bank should act as a lender of
last resort to avoid systemic panic and liquidity crises due to bank runs.
These particular loans are not intended to be free and indiscriminate.
Bagehot (1983) makes a clear distinction between illiquid and insolvent institutions.
One of the main issues in banking business is that short-term liabilities like deposits are
seldom invested in long-term illiquid assets – corporate borrowing, mortgages, etc. –;
this phenomenon is called maturity mismatch.
In times of crisis and especially during bank runs it is extremely likely for banks to face
liquidity problems even if they are financially solid, and that’s the exact case of an
illiquid institution. Diamond and Dybvig (1983) explain how it usually happens: despite
certainty about the soundness of a bank, depositors may run due to coordination
problems.
Each depositor is aware that if the other ones withdraw early, the bank would have to
convert illiquid assets into cash at a loss and therefore might not have enough cash to
cover all the requests.
On the other hand insolvency occurs when a firm’s debts exceed its assets.
According to Bagehot (1873), the central bank should lend freely to illiquid banks at a
high rate of interest in exchange for financial assets, while the second case is a
symptom of bad management and insolvent banks should be left failing, as “Any aid to
a present bad bank is the surest mode of preventing the establishment of a future
good bank.”
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However, distinguishing between illiquid and insolvent banks is not as easy as it could
seem. Some economists argue that it can be very difficult for the central bank to check
the real status of a bank, especially in chaotic moments when decisions have to be
made very quickly. As a matter of fact the Federal Reserve, facing in 2008 the concrete
5
Baird (2009)
6
Bagehot (1873)
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possibility of an imminent general liquidity shock had no choice but lending to both
illiquid and insolvent banks.
Bagehot itself complained about the low transparency of the banking system, but
suggested “good collateral”, described as any paper accepted by the central bank, as a
discriminant; unfortunately the nowadays growing complexity of the financial system
have made it more and more difficult to verify the assets’ real quality and banks’
balance sheets are often a Pandora’s Box.
Lombard Street is without any doubt the most notorious book for what concerns the
lender of last resort topic and is the flagship of the “Classic theory”, but it wasn’t the
first to write about it.
This myth was discredited by Charles Goodhart (1999): Bagehot’s ideas were
anticipated by another English economist who also worked as banker. His name was
Henry Thornton and in 1802 he wrote An Enquiry into the Nature and Effects of the
Paper Credit of Great Britain, a work of great importance that gave a detailed account
of the British monetary system as well as a detailed examination of the ways in which
the Bank of England should act to counteract fluctuations in the value of the pound.
Bagehot only puts more emphasis on the need to raise interest rates to deter
unnecessary domestic borrowing, even if, unlike most economists think, he never
talked about higher-than-available penalty rates.
1.2.2 Moral Hazard vs. Systemic Panic
Neither Bagehot nor Thornton was given the attention they deserved anyway. They
surely inspired the birth of the Federal Reserve in 1913 (Dallas Fed President Richard
Fisher called Bagehot “a patron saint” in a 2009 speech)
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, but as said before it didn’t
provide any lender of last resort support during the ’29 economic disaster.
Their contributes seem to have been forgotten until the last two decades and the LOLR
literature remained quite modest in size although economists like Friedman (1960) and
Minsky (1985) counseled that a central bank should take this role pumping the
necessary liquidity for banks, corporations and even individuals.
7
Dallasfed.org (2009)
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One possible reason may come from the main “antagonist” and contraindication to
such measures, the phenomenon known as moral hazard.
By saving both illiquid and insolvent banks, the Fed has sent a clear message:
whenever a financial crisis occurs its priority will be to avoid that things go out of
control, not to punish the culprits. Therefore, the next time something similar
happens, banks and other financial firms could be forgiven for believing that the Fed
will rescue them once again in the name of stability.
This is the main burden the acting as LOLR carries on shoulders: the guilty ones could
be pushed to never learn from their errors. Yet the high level of interconnection of the
worldwide banking system could leave no choice but lend, as if the central bank
refuses to be a lender of last resort a contagious systemic panic would extent losses in
a pandemic way.
Bagehot (1873) suggested a method to reduce, although not to eliminate, the moral
hazard problem through imposing a high rate (relative to the pre-crisis period) but this
may: (I) aggravate the bank’s crisis; (II) send a signal to the market that precipitates an
untimely run; and (III) give the managers incentives to pursue a higher risk-reward
strategy in order to repay the higher rate (‘gamble for resurrection’).
As said before, some economists think that the British businessman’s recommended
rate for such loans wasn’t only intended to be high; it should be a ‘penalty rate’, higher
than that available in the market place.
Goodhart (1999) rejects this theory, stating that proofs of it are nowhere to be found
in Lombard Street. The rate should be above that in effect in the market prior to the
panic, but not necessarily above the contemporaneous market rate.
Bagehot was concerned that, if neither the Bank of England lent on the basis of good
collateral, no one else would do it. Without collateral, the penalty rate would have
then been infinite.
Even if moral hazard is a concrete and pervasive threat, the ’29 crisis non-
interventionist Fed policy has shown how huge the extent of economic losses can be in
case of a contagious systemic panic.
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