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Lender of last resort wray
Lesson 1-4-2015
Bagehot’s principles
• lending to only solvent banks, against good
collateral, and at “high” or penalty rates.
Criticsm of mehrling
• A bank that knows an asset is bad and sells it
at an inflated value to a lender of last resort
will have to come up with the difference in
value in the future or the bank will fail. This is
a strong disincentive to passing bad assets,
particularly in 19th c. financial systems where
bankers’ personal assets’ were on the line.
• It is precisely this disincentive to passing bad
assets off on the central bank that the authors
apparently wish to eliminate by establishing a
dealer of last resort – and that they claim is a
policy that Bagehot would have supported.
• The distinctions between the 19th c.
environment and the modern environment
are very important, and are neither addressed
– nor indeed even acknowledged – by
Bagehot was a Shadow Banker.
• The Bank of England determined which assets
were worthy of being discounted in an
environment where almost no bad assets
circulated: the assets eligible for discount
were of high quality, not only because they
had very short maturities.., but also because
the bankers who circulated the assets put
their personal wealth at risk by accepting
them and then discounting them.
Sissiko criticism
• Note that Figure 2 also errs in indicating that
bills discounted at the Bank of England were
accompanied only by the guarantee of the
acceptor. In fact, the discounter also
guaranteed payment on the bill. Thus, every
bill held by the Bank was supported by the
credit of at least three parties, the issuer, the
acceptor, and the discounter. Each of these
parties was liable for the full value of the bill.
sissiko
• The authors describe the private bill market of
Bagehot’s time as “a market in short-term
private debt, typically collateralized by
tradable goods.” (at 5) The private bills that
circulated in Bagehot’s era were not
collateralized.
thornton
• Suppose that A sells one hundred pounds
worth of goods to B at six months credit, and
takes a bill at six months for it; and that B,
within a month after sells the same goods, at
a like credit, to C, taking a like bill; and again
that C, after another month, sells them to D,
taking a like bill, and so on.
Bills Not collateralized
• In short, the whole point of the 19th c. system
of private bills in Britain is that they were not
collateralized, instead they were typically
generated as part of the process of trade (that
is, even under the acceptance credit system,
goods were regularly transferred, there was
just no requirement that every bill be created
in the process of such a transfer).
• There may then, at the end of six months, be
six bills of £100 each existing at the same
time; and every one of these may possibly
have been discounted. Of all these bills, then,
one only represents any actual property.”
• The authors of Bagehot was a Shadow Banker
define shadow banking as “money market
funding of capital market lending” and
describe it as “the centrally important
channel of credit for our times” (at 2).
• Capital market lending generally refers to
lending with a maturity in excess of one year,
and contrasts with lending on money markets
for terms of one year or less.
• Funding long-term assets with short-term
liabilities creates funding risk, that is, the risk
that you can’t pay the maturing paper by
rolling it over into new short-term debt, and
relies on bank guarantees in the form of
liquidity facilities or tri-party clearing bank
guarantees to address this risk. Funding longterm assets with short-term liabilities also
creates market risk, the danger that the value
of the assets drops significantly below the
• Funding long-term assets with short-term
liabilities also creates market risk, the danger
that the value of the assets drops significantly
below the value of the short-term liabilities
before they are refinanced.
• Another important characteristic almost
certainly differentiates 19th c. money market
assets from those of modern markets: the
personal liability of the issuers and the
guarantors.
Unlimited liability
• By contrast in 19th c. Britain, issuers and
bankers faced unlimited liability – or capital
calls if they were stockholders – on their
obligations. Because of the personal stake that
the bankers and the owners of banks had in
the success of their business, the general
credit quality of both assets and acceptances
in 19th c. Britain was almost certainly higher
than that of the underlying assets or CDS of
modern markets.
Cds issued by modern corporation
• Thus, another important distinction between
a CDS and an acceptance is the fact that a CDS
is issued by a modern corporation whereas an
acceptance was issued by either an
unincorporated firm or a 19th c. British joint
stock firm.
• Not only were the bank guarantees in 19th c.
Britain of higher credit quality than those
issued by modern corporations, but the
underlying assets were most likely of higher
credit quality too.
• D. Shadow Banking is Not “Market-Based”
Lending
• The “market-based” credit system is often
contrasted with the “bank-based” credit
system to distinguish environments where
firms raise funds by issuing securities on
markets from those where firms raise funds by
borrowing from banks.31
• When it comes to money markets, however,
the line between market-based and bank-
• When it comes to money markets, however,
the line between market-based and bankbased systems cannot be clearly drawn,
because the so-called market-based systems
rely heavily on guarantees provided by the
banking system.
In commercial paper markets non-financial companies,
including ABCP conduits, can only borrow on these
markets if they have liquidity support, usually in the form
of a liquidity facility, repo or swap provided by a bank.
Bank-guaranteed credit system
• second, it was also backstopped by guarantees
provided by the tri-party clearing banks, which
bore the credit risk of the dealer banks during
the day. In short, in the money markets the
“market-based” credit system might as well
be called the “bank-guaranteed” credit
system.
• Repo liabilities commercial paper have no big
secondary markets.
• 19° century instead
• Active secondary market for the bills
• It is misleading to describe the shadow
banking system that exists today as “money
market funding of capital market lending” and
to focus on it as a means of financing assets,
because at present by far the most important
use of shadow banking instruments is to
provide wholesale funding for investment
banks and through them indirect financing of
assets that sit on their balance sheets.
• If unsecured credit falls into disuse, it is not
clear that the money supply will be able to
grow with the needs of the economy.
Whereas traditional money markets
supported economic growth through the issue
of high-quality unsecured debt, modern
collateralized money markets – to the degree
that they fund private sector assets at all –
fund instruments that trade actively and have
meaningful market prices, although they may
Failure of collateralized markets
• To the degree that modern money markets
are no longer able to expand the money
supply to meet the needs of individuals and
small businesses, but instead are constrained
to rely on collateral issued by governments
and large companies, they may fail to meet
the needs of the economy and to support
economic growth.
• In short, it is not clear that collateralized
money market instruments can play the same
role in expanding the money supply and in
economic growth as that played by unsecured
money market instruments.
• To summarize, modern collateralized money
markets are likely to face more sudden
demands for liquidity than traditional
unsecured money markets because (i) margin
calls are made on a daily basis, not when the
debt matures; (ii) the leverage inherent in
collateralized borrowing can force borrowers
to sell collateral in order to pay off loans
aggravating the price decline;
• and (iii) the reliance of the market upon
collateral means that when price falls all
lenders make margin calls simultaneously.
• Unlike traditional unsecured money markets
where it took many individual decisions by
independent lenders to create a panic,
liquidity crises in collateralized markets are
an almost mechanical function of declines in
the price of collateral – that are exacerbated
by the market’s reaction to the decline in
price.
• This action can be distinguished from the
traditional lender of last resort action
because:
• (i) The lending took the form, not of wrapped
sales, but of collateralized loans, where the
lender has the right to demand additional
collateral on a daily basis.
• (ii) The central bank did not lend only against
high-quality assets, but on many days
accepted tens of billions of dollars of equities,
junk and unrated securities from each of a
variety of primary dealer borrowers.139
• (iii) In collateralized money markets the
temporary provision of cash is not sufficient to
quell a crisis.
Wray on llr
Fed’s lending rates
• We provide a detailed analysis of the Fed’s
lending rates and reveal that it did not follow
• Bagehot’s classical doctrine of charging
penalty rates on loans against good collateral.
• Further, the lending continued over very long
periods, raising suspicions about the solvency
of the institutions.
Others, however, have criticized the Fed as being
anything but classical not only in exceeding
traditional bounds in the magnitude of its
balance sheet expansion but also for rescuing
unsound institutions rather than limiting its
assistance to solvent but illiquid firms, for
accepting worthless collateral in security for its
loans, for charging subsidy rather than penalty
loan interest rates, and for channeling aid to
privileged borrowers rather than impartially to
the market in general.
Llr policy
classicals viewed LLR policy as part and parcel of
the central bank’s broader responsibility to
protect the stock of bank-created money from
contraction (and to expand it to compensate
for falls in its circulation velocity).
Money protection function
The central bank fulfills its money protection
function by pre-committing to expanding
reserves without limit to accommodate panicinduced increases in the demand for money.
Avoid to dump assets
By creating new reserves on demand for sound
but temporarily illiquid banks, the LLR makes it
unnecessary for those banks, in desperate
attempts to raise cash, to dump assets at firesale prices that might render the banks
insolvent and would reduce the outstanding
supply of bank money (as loans are called in
and deposits are debited.)
llr
Thornton especially, but Bagehot too,
understood that the central bank’s
distinguishing feature as an LLR consists of its
monopoly power to create unlimited amounts
of high-powered money in the form of its own
notes and deposits, items whose legal tender
status and universal acceptance mark them as
money of ultimate redemption and the
equivalent of gold coin.
Special responsibility
Unlike the bank, whose duties extend only to its
stockholders and customers, the LLR’s
responsibilities extend to the entire
macroeconomy. This special responsibility
dictates that the LLR behave precisely the
opposite of the banker in times of stress,
expanding its note and deposit issue and its
loans at the very time the bank is contracting.
Money view
It follows that the LLR must draw a sharp
distinction between the asset,or credit (loans
and discounts) side, and the liability, or money
(notes and deposits) side of bank balance
sheets. Although the two aggregates, bank
credit and bank money, tend to move
together, it is panic-induced falls in the latter
rather than the former that render damage to
the real economy.
money
Because money forms the transaction medium
of final settlement, it follows that its
contraction— rather than credit crunches and
collapses—is the root cause of lapses in real
activity.
Central bank
To prevent this sequence of events, the LLR
must stand ready to accommodate all panicinduced increases in the demand for highpowered money, demands that it can readily
satisfy by virtue of its open-ended capacity to
create base money in the form of its own notes
and deposits.
• Most recently, in the financial crisis of 2008–
09, the Fed adhered to some classical
• principles, while it departed from others.18 C
Evaluation of policy
Consistent with the classical model, it provided
reserves to the banking system, albeit with
some delay and in a rather haphazard manner
(as detailed in our 2012 report). These injections
were sufficient to resolve the crisis (but
insufficient to prevent the recession or to boost
the weak recovery even after several
rounds of quantitative easing).
Quality of collateral
• What was inconsistent with Bagehot’s advice, however,
was that much of this collateral was complex, opaque,
hard-to-value, illiquid, difficult to buy and sell, risky,
and liable to default—hardly good security. The Fed
also purchased outright from banks and other financial
institutions assets such as commercial paper, securities
backed by credit cards, student loans, auto loans, and
other assets, and mortgage-backed securities and
debts of GSEs. Finally, it guaranteed debt of Citigroup,
and extended loans to insurance giant AIG, both of
them insolvent firms deemed too big and too
interconnected to fail.
departures
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•
•
•
•
•
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Emphasis on Credit Instead of Money
Taking Junk Collateral.
Charging Subsidy Rates
Rescuing Unsound Firms Too Big to Fail.
Extension of Loan Repayment Schedules
No Pre-announced Commitment
No Clear Exit Strategy
Excess reserves
The excess arose originally from the Fed’s
emergency lending activities after August 008,
increasing from less than $2 billion in August
to $767 billion by year-end 2008.
Quantitative easing
Afterward, throughout 2009 and until mid-year
2010, the Fed engaged in the first major
quantitative easing program of purchases of
government agency debt and agency
guaranteed mortgage-backed securities. The
Fed’s purchases reached a cumulative total of
$1.285 trillion, and excess reserves reached
nearly $1 trillion.
Reserves use
the new reserves provided by the purchases
program enabled the banking system to fund
the repayment of about $1 trillion of various
forms of advances to financial institutions
under the emergency lending program. The
emergency lending program ended, but
quantitative easing replaced it.
Second round QE
In early 2011, the Fed began its second round of
quantitative easing, aimed at purchasing
about $600 billion of longer-term Treasury
securities. When the program ended in June
2011, $581 billion had been added to excess
reserves, with the peak amount reached in
July 2011, $1.618 trillion. The peak amount of
monetary base that same month was $2.681
trillion.
No increase in bank credit
The Fed should have learned from the
experience of the quantitative easing
programs that its purchases of securities did
little or nothing to increase the quantity of
bank credit actually supplied to the general
economy.
QE3
• This past September the Fed announced a full-speedahead procession with QE3. This time, the Fed
promised to buy $40 billion worth of mortgage-backed
securities (MBSs) everymonth through the end of the
year, and to keep what is essentially a zero interest-rate
policy (ZIRP) in place through mid-2015. The Fed also
announced that it will purchase other long-maturity
assets to bring the total monthly purchases up to $85
billion, with the bias toward the long end expected to
put downward pressure on long-term interest rates.
The Fed made clear that QE3 is open-ended, to
continue as long as necessary to stimulate to a robust
economic recovery.
graph
How the fed pays for assets
• When the Fed buys assets, it purchases them by
crediting banks with reserves. The result of QE is that
the Fed’s balance sheet grows rapidly—to, literally,
trillions of dollars. At the same time, banks exchange
the assets they are selling (the Treasuries and MBSs
that the Fed is buying) for credits to their reserves held
at the Fed. Normally, banks try to minimize reserve
holdings—to what they need to cover payments
clearing (banks clear accounts with one another using
reserves) as well as Fed-imposed required reserve
ratios. With QE, the banks accumulate large quantities
of excess reserves.
Lend out reserves
• A lot of people—including policymakers—exhort the
banks to “lend out the reserves” on the notion that this
would “get the economy going.” There are two
problems with that thinking. First, banks can lend
reserves only to other banks—and all the other banks
have exactly the same problem: too many reserves. A
bank cannot lend reserves to households or firms
because they do not have accounts at the Fed; indeed,
there is no operational maneuver that would allow
anyone but a bank to borrow the reserves (when a
bank lends reserves to another bank, the Fed debits
the lending bank’s reserves and credits the borrowing
bank’s reserves).
…
• The second problem with the argument is that
banks do not need reserves in order to lend.
• What they need is good, willing, and creditworthy borrowers.
qe
What QE comes down to, really, is a substitution
of reserve deposits at the Fed in place of
Treasuries and MBSs on the asset side of
banks. In the case of Fed purchases of
Treasuries, this reduces bank interest
income—making them less profitable.
Effectively, the banks are moving losers off their
balance sheets in order to get safe reserves
that earn next to nothing. That is a good
trade! But, again, it does not induce banks to
make more loans, does little to stimulate Main
Street, and creates moral hazard in the
financial system as it teaches banks an
invaluable lesson: too dumb to fail.
Rates for top 8 borrowers
continues
• The Fed lent huge volumes of reserves at low
interest rates over a very long period. There are
two ways of perceiving this. First, it could be seen
as an interest rate subsidy to (largely) big banks
and to credit markets more generally—a gift
provided by the Fed to purportedly solvent
institutions. The second possibility is that these
institutions were suffering from insolvency, not
liquidity problems. They could not borrow at
reasonable interest rates in markets, and so the
Fed had to lend to them for extended periods to
try to restore solvency.
Subsidy to insolvent banks
• Lending at low rates to insolvent banks for a
sustained period of time (with an average of
almost two years) can have the effect of
increasing bank profitability. It is of little
wonder that the crisis was mitigated after the
Fed bought $1.25 trillion in possibly toxic
assets.
undemocratic
• By doing so, it not only circumvented the
normal functioning of financial markets but it
also circumvented the democratic process.
Lending at or below market rates, allowing
banks to negotiate these rates through
auctions, and rescuing insolvent banks has
validated not only unstable banking
instruments and practices but also has
perhaps set the stage for an even greater
crisis.
No liquidity crisis
In addition, the extraordinary extension of the
terms of the facilities is not consistent with a
liquidity crisis.