Question

Assess how the Federal Reserve implements Bagehot’s dictum as a means of fostering economic growth in the current period.

Do you agree with the policy that, “in modern financial markets, the Bagehot principle of providing lender-of-last-resort support remains necessary but is no longer sufficient”? Evaluate the changing role of government regulation in mitigating systemic risk, providing evidence to support your view.

Do you agree or disagree with government intervention? Defend your stance using supporting theory or evidence.

Answer 1

Above question is answered/discussed on the basis of 2007 August Crisis: this is the evidence considered in the answer and the entire context is to be read and understood keeping this Crisis of 2007 in mind.

Bagehot’s dictum is well founded: By lending freely, the central bank may be able to quell powerful panic-driven demands for liquidity and their potentially untoward effects on the economy. Providing a virtually unlimited source of liquidity to institutions can avert the fire sales that can lead to decreases in asset values, reductions in wealth, and ultimately to a costly contraction in economic activity. And providing liquidity can enable a continuation of the lending by financial institutions that is necessary to support activity at the economy’s potential. We might call this the macroeconomic rationale for Bagehot’s dictum – promoting the full employment of resources. Central banks provide liquidity insurance to the banking system, which in turn provides liquidity insurance to the rest of the economy (households and businesses). Thus, central bank plays an important role in fostering economic growth.
Henry Thornton and Walter Bagehot are the two authors who developed the key elements of the classical doctrine of the lender of last resort ( LOLR). According to Bagehot, in an emergency situation monetary authorities should lend unsparingly but at a penalty rate to liquid but solvent banks. In addition, the rules under which assistance would be provided lending freely at penalty rates against sound collateral should be clearly stated beforehand in order to avoid needless uncertainty. To summarize, both authors explained the need for an LOLR and described its principles as follows :
To prevent the decline in the money stock from panics;
To set policy in function of the longer range monetary growth target;
To provide support to the overall financial system instead of particular banks;
To state policy in advance so as to remove uncertainty that could contribute to a panic;
To make loans only to solvent banks in return for high-quality financial assets;
To grant all illiquid banks access to credit at a high rate.

Bagehot's dictum can be viewed as having a sound foundation in microeconomics—
1. directed at promoting the efficient allocation of resources. By lending only to solvent firms, by lending only against good collateral, and by charging a penalty rate, central banks can limit the moral hazard and other distortionary effects of government intervention in private financial markets that can impair the efficiency of the economy. Specifically, lending only to sound institutions and lending only against good collateral sharpens firms' incentive to invest prudently in order to remain solvent;
2.lending only at a penalty rate preserves the incentive for borrowers to obtain market funding when it is available rather than seeking recourse to the central bank;
3 Maintaining these incentives to the greatest extent possible helps promote the efficient allocation of society's resources.

In the modern era, central banks in market economies generally do not engage in routine lending to institutions that do not have a banking charter. When financial markets and institutions are functioning normally, a central bank has no need to extend credit to nonbank institutions. Extending credit to nonbank firms is held in normal times to be the job of commercial banks and other private lenders. In contrast, the task of a central bank in such circumstances is to ensure that short-term interest rates and the aggregate quantity of money and credit are suitable to promote macroeconomic objectives such as maximum employment and stable prices, primarily using market-based tools like open market operations. Central banks can accomplish this task by restricting their usual lending operations to banks, leaving the allocation of credit across banks and in the broader economy to market mechanisms.

However, the absence of a routine reason for lending to nonbank institutions does not mean that central banks never need the authority to lend to such entities. Bagehot clearly saw this point. His remark that central banks must be prepared to lend to "this man and that man" implies that he drew no sharp distinctions among potential recipients of central bank funding in a panic.

And indeed, from the very beginning of this crisis, events have demonstrated the potential for losses among nonbank firms to lead to systemic disruptions. For example, large redemptions from three funds operated by BNP Paribas, coupled with illiquid conditions in the markets for their assets, prompted the bank to shutter those funds on August 9, 2007, a development that was the immediate cause of intense money market pressures on that first day of the crisis. Over the course of the crisis, many other nonbank entities, including money market funds, conduits, structured investment vehicles, investment banks, and other financial firms experienced what amounted to bank runs. The resulting strains were felt immediately in bank funding markets as well, with rising rate spreads and sharply reduced liquidity, especially for term borrowing, as counterparty credit concerns mounted.

Conclusion: from the above discussion it can be drawn
Firstly, that the Federal Reserve's experience in Bagehot's dictum continues to provide a useful framework for designing central bank actions for combating a financial crisis. However, that framework needs to be interpreted in the context of the modern structure of financial markets and institutions and applied in a way that observes both legal constraints and a broad range of practical considerations. The experience of the crisis shows that, in extraordinary circumstances, central banks may well need to take measures to prevent systemic collapse that are unprecedented in their details; but such measures may still be quite congruent with established central banking principles.
Secondly, the problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms. In absence of such reluctance, conditions in interbank funding markets may have been significantly less stressed, with less contagion to financial markets more generally. Central banks eventually were able to take measures to partially circumvent this stigma by designing additional lending facilities for depository institutions; but analyzing the problem, developing these programs, and gathering the evidence to support a conclusion that they were necessary took valuable time. Going forward, central banks and other policymakers need to avoid measures that could further exacerbate the stigma of using central bank lending facilities
Thirdly, the severe difficulties encountered by primary dealers in this crisis, and the evident consequences for broader effects on the financial system and the economy, illustrate a broader point: Any financial system that includes systemically important nonbank financial firms with significant amounts of illiquid assets and short-term liabilities--in other words, any system that includes important nonbank financial firms subject to bank-like runs--requires a mechanism for lending to such firms at least in crisis situations,
Finally, experience suggests that a workable regulatory system must incorporate a mechanism to extend central bank credit to entities that are not normally eligible to borrow from the central bank; no reasonable system of regulation can draw a bright line that cannot be crossed between banks and nonbanks. Due to absence of such regulation, there will always be a continuum in the degree to which financial firms pose systemic risk. Subjecting systemically risky firms to enhanced supervision and regulation is certainly warranted. But practical considerations will always require that only a well-specified set of institutions subject to a specific supervisory regime have regular access to central bank credit, and that firms outside the boundary do not have such access.

In summary, the recent financial crisis provides considerable evidence in support of what Bagehot knew more than 135 years ago from the experience of his era. To cushion the adverse effects of a financial panic on economic activity, a central bank must be ready to lend freely, potentially to a broad range of counterparties, in a crisis. Although the need for a modern central bank to lend in normal times may be quite limited, it is not prudent to severely circumscribe the potential scope for central bank lending in a financial panic. Rather, as Bagehot recommended, we should look to the restrictions of lending only to solvent firms, only against good collateral, and only at high rates to limit distortionary effects on markets and to protect the fisc while allowing central bank credit to prevent financial panics from having excessively adverse effects on economic activity and employment.