Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation

By Jean-Charles Rochet | Go to book overview

Chapter Two

Coordination Failures and the Lender of Last
Resort: Was Bagehot Right After All?

Jean-Charles Rochet and Xavier Vives


2.1 Introduction

There have been several recent controversies about the need for a lender of last resort (LLR) both within national banking systems (the central banks) and at an international level (the IMF).1 The concept of an LLR was elaborated in the nineteenth century by Thornton (1802) and Bagehot (1873). An essential point of the “classical” doctrine associated with Bagehot asserts that the LLR role is to lend to “solvent but illiquid” banks under certain conditions.2

Banking crises have been recurrent in most financial systems. The LLR facility and deposit insurance were instituted precisely to provide stability to the banking system and to avoid unfavorable consequences for the real sector. Indeed, financial distress may cause important damage to the economy, as the example of the Great Depression makes clear.3 Traditional banking panics had been eliminated with the LLR facility and deposit insurance by the end of the nineteenth century in Europe and after the crisis of the 1930s in the United States; and they have almost disappeared from emerging economies, which have until now suffered numerous crises.4 Modern liquidity crises associated with securitized money or capital markets have also required the intervention of the LLR. Indeed, the Federal Reserve intervened in the crises provoked by the failure of Penn Central in the U.S. commercial paper market in 1970, by the stock market crash of October 1987, and by Russia's default in

1See, for instance, Calomiris(1998a, b), Kaufman (1991), Fischer (1999), Mishkin (2000),
and Goodhart and Huang (1999, 2000).

2The LLR should lend freely against good collateral, valued at precrisis levels, and at
a penalty rate. These conditions are due to Bagehot (1873) and are also presented, for
instance, in Humphrey (1975) and Freixas et al. (1999).

3See Bernanke (1983) and Bernanke and Gertler (1989).

4See Gorton (1988) for U.S. evidence and Lindgren et al. (1996) for evidence on other
IMF member countries.

-37-

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