Political Foundations of the Lender of Last Resort

Lambert here: I like “the recent Global Crisis.” It reminds me of “the late unpleasantness.”

By Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University Graduate School of Business, Marc Flandreau, Professor, Graduate Institute, Geneva and CEPR Research Fellow, and Luc Laeven, Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow. Originally published at VoxEU.

The recent Global Crisis has prompted the major central banks to conduct lender of last resort (LOLR) operations on an unprecedented scale and stirred up a debate on the constraints and boundaries of LOLR policies (see Bindseil 2014 for an overview of such operations in the recent crisis). For instance, the Federal Reserve, the ECB and the Bank of England have each assisted banks with special loans and asset purchases designed to bolster banks’ positions, expand the supply of liquidity, and reduce the risk of deposit withdrawals.

Yet, the degree to which central banks provided LOLR assistance to banks during the crisis was not uniform, nor was structure of such assistance the same across countries. Interestingly, such differences have been commonplace throughout history (see Bordo 1990 for an early account of the LOLR function throughout history; and Bignon et al. 2012 for a modern appraisal). For one, while central banks empowered to act as LOLR were commonplace in Western Europe by the middle of the 19th century, central banks were not created in the US until 1913, in Canada until 1935, and in Australia until 1959. The techniques of lending of last resort varied across countries and were deeply influenced by local conditions and institutions. Collateral rules for LOLR loans, including haircuts, have varied markedly across institutions and over time. In some cases only banks were eligible for emergency lending, in other cases such as in the influential British experience, lending was extended also to nonbanks. Finally, LOLR assistance sometimes has not been limited to loans, or to central bank operations. Government assistance through credit guarantees, preferred stock, and common stock investments has been a feature of LOLR assistance in response to particularly severe financial system shocks as early as the late 19th century.

History of the Lender of Last Resort

In a recent paper (Calomiris et al. 2016), we examine the history of the development of the LOLR throughout the world, and explore how politics and economics interacted to produce the heterogeneous evolution of LOLR structures and actions around the world. Do such differences merely reflect differences in economic fundamentals that LOLR respond to, or also differences in the operational frameworks of central banks and political support for government assistance?

We define LOLR as central bank or government assistance to financial intermediaries in the form of emergency loans, guarantees, or asset purchases (including preferred or common stock purchases) to provide the needed liquidity or financial strength to end runs on short-term debt claims. Those actions allow financial intermediaries to continue to provide transaction services through the payments system and to provide credit to borrowers without access to capital markets.

Our historical account shows that differences in the structure and function of lenders of last resort reflect major political obstacles to establishing LOLRs and adopting effective rules for LOLR policy, and cannot be explained by economic differences alone. This was the case in early 19th century Britain, where the institutional changes that gave the Bank of England LOLR powers and responsibilities, following a succession of banking crises, were controversial and contested. In the US, the development of a LOLR was delayed as a result of political opposition, and when the Federal Reserve System was created in 1913, its structure and powers were circumscribed by restrictive legislation. The Fed’s powers were narrowly confined to engaging in collateralised rediscounts and advances on certain classes of assets with member banks.  In contrast, the Bank of England was permitted ample room for improvisation.

The experiences of Canada and Australia also illustrate unique central bank chartering outcomes, which reflect their own political histories. Canada’s classically liberal political environment eschewed central banking until 1935. Instead, Canada relied on interbank coordination to avoid banking crises. The establishment of the Bank of Canada in 1935 reflected monetary goals rather than any perceived failings due to the absence of a LOLR. Australia did not create a full-fledged central bank until 1959, which was the culmination of a protracted political struggle over the appropriate allocation of power over money and credit.  More recently, political constraints that reflect the allocation of political powers within the euro area have played an important role in defining and limiting LOLR actions of the ECB to deal with banking crises within the euro area.

The LOLR is a locus of political power, and as such, its creation should be viewed as the outcome of a political bargain (Calomiris and Haber 2014). It is therefore not surprising that countries differed in their propensity to create LOLRs, and in the powers with which they chose to endow them. LOLRs began as collateralised lenders empowered and required to provide credit to banks that were otherwise unable to fund their needs during crises, but LOLRs’ statutory powers changed over time in varied ways.

We trace changes over time in the approaches used by central banks and governments to deal with financial crises from the late 19th century to the late 20th century. We identify a shift in the scope of LOLRs away from a narrow reliance on collateralised lending to an approach including also other forms of support, including credit guarantees, preferred stock assistance, and other mechanisms. We relate this shift in part to the need to expand LOLR activity to a broader set of interventions in the case of systemic banking crises.

Although the mechanisms and reach of LOLRs expanded to include a wide variety of tools, which were employed to deal with varied circumstances, until the 1980s, most countries managed to construct policies that dealt with systemic threats while avoiding blanket protection of all banks’ liabilities. Even though LOLR assistance evolved to include approaches other than collateralised lending, historical assistance was selectively used only to address systemic threats, and when assistance was provided, it adhered to what we refer to as ‘Bagehot’s Principles’, building on Bagehot’s (1873) treatise:  central banks were encouraged to focus on the health of the financial system, rather than on the fate of individual banks. Failure of financial institutions was permitted unless there was a credible systemic risk associated with their failing. During episodes of systemic crises, LOLRs would take on some default risk as a necessary part of their role in assisting the banking system, but only within limits – banks as a whole had to bear most of the risk from such assistance. The participation of banks in risk sharing ensured that assistance would be selective.

Although historical LOLR assistance did not follow an explicit rule, because its structure generally adhered to Bagehot’s principles, assistance minimised adverse fiscal and moral hazard consequences. In many countries, including Britain and France, the structure of LOLR operations was explicitly intended to prevent severe fiscal consequences. While effective interventions necessarily involved risk taking by the LOLR, they usually turned out to be profitable – at least when measured on an ex post, cash-flow basis – because support was provided at a high price and with limited risk, taking advantage of the central bank’s monopoly position in the provision of liquidity.

After WWII, and especially after the 1970s, generous safety net protection became the norm, and in some cases offered unlimited depositor protection (at least ex post). Unlimited protection eliminates the risk of depositor loss and prevents any bank of significant size from failing, regardless of whether the bank poses a true systemic risk. Such protection is generally achieved via a combination of deposit insurance and ad hoc government bailouts of banks through injections of taxpayer funds. Protecting risky banks from the discipline of deposit withdrawals keeps bank credit flowing, which can be particularly beneficial to politicians anticipating an election, but such protection entails social costs in the form of greater risk-taking and large potential fiscal consequences due to long-term financial losses of protected banks, and output losses from the financial crises that protection encourages.

A Comparison Across Countries

We perform a detailed comparison of 40 countries’ statutory provisions for central bank lending in 1960, and follow the changes in LOLR legislation in 12 of those countries from 1960 to 2010. We measure differences in central banks’ LOLR powers across several dimensions and consider possible explanations of those differences. We find that countries differ greatly in the extent of their LOLRs’ statutory powers. Those powers change little over time, except in response to crises. Countries with relatively powerful LOLRs in 1960 – in particular, those whose LOLRs enjoyed the power to issue guarantees – tended to be less generous in their level of deposit insurance coverage as of 1980. These findings suggest there may be some substitutability between LOLR activities and depositor protection.

Our historical analysis shows that, in general, there has been a lack of clear rules established by government that determine what sort of assistance can be supplied by the LOLR, and the process that determines how assistance would be provided. Instead, assistance by central banks and governments usually has been provided through ad hoc responses to events.

Obviously, rules matter because they affect incentives of market participants and thus can limit moral hazard. If banks know that assistance will be limited to certain circumstances and provided according to pre-established rules, that creates an incentive for banks to manage risk and maintain liquidity and capital to protect themselves from risks that are not protected. Furthermore, if market participants are aware of a commitment by the government or the central bank to provide LOLR assistance to address systemic risks, the expectation of assistance can help to stabilise the financial system by acting on market participants’ expectations.

Concluding RTemarks

We conclude that the LOLR function should strike a balance between the need to respond to severe systemic shocks in a flexible and timely manner and the desire to mitigate moral hazard through pre-established ruled that set limits on assistance. We also recognise, however, that failures to achieve the proper balance reflect the central reality of LOLR design, which is that LOLRs are the outcomes of political bargains.

Authors’ note: The views expressed here are our own and should not be interpreted to reflect the views of the ECB.


Bagehot, W. [1873] (1962), Lombard Street: A Description of the Money Market, Homewood, IL: Richard D. Irwin.

Bindseil, U. (2014), Monetary Policy Operations and the Financial System, Oxford: Oxford University Press.

Bignon, V., M. Flandreau, and S. Ugolini (2012), “Bagehot for Beginners: The Making of Lender-of-Last-Resort Operations in the Mid-Nineteenth Century.” The Economic History Review, 65, pp. 580–608.

Bordo, M. D., (1990), “The Lender of Last Resort: Alternative Views and Historical Experience,” Economic Review, Federal Reserve Bank of Richmond, January/February, pp. 18-29.

Calomiris, C. W., M. Flandreau, and L. Laeven (2016), “Political Foundations of the Lender of Last Resort: A Global Historical Narrative,” CEPR Discussion Paper No 11448. 

Calomiris, C. W., and S. H. Haber (2014), Fragile By Design: The Political Origins of Banking Crises and Scarce Credit, Princeton: Princeton University Press.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Jim Haygood

    Why do we need LOLZ (Lender of Last ZIRPs) in the first place?

    One reason is that because banks borrow short and lend long, in a crisis some of their assets (such as loans) aren’t liquid to meet withdrawals.

    A second, more pernicious reason is leverage: even under tightened Basel III rules, the minimum Tier 1 capital ratio is 6 percent for Systemically important financial institution (SIFI) banks and 5 percent for their insured bank holding companies.

    These are purely arbitrary, ad hoc levels of leverage, allowing banks to pyramid their equity base by up to 20 times.

    Banks’ position is analogous to a seller of stock index puts: 95% of the time, you can make a nice steady income by selling out-of-the-money puts to parties desiring portfolio protection, and pocketing the premium when the puts expire worthless, as they usually do.

    But 5 percent of the time, a 2008-style meltdown comes along, leaving the put seller exposed to unlimited losses, many times the size of the premium.

    This is leveraged banks’ game. They want to collect the easy money during the stable periods, and have the public backstop them during crises, when their excessive leverage certainly will tip them over.

    Is this a sustainable business model? Not if the taxpayers declare, f*** no, we won’t pay.

    1. BecauseTradition

      Why do we need LOLZ (Lender of Last ZIRPs) in the first place? Jim

      Because the indispensable payment system must work through depository institutions because, ya see, only they in the private sector may have accounts at the central bank.

      Why is that? Because TRADITION!

    2. fresno dan

      Jim Haygood
      September 19, 2016 at 8:45 am

      In an era of as much fiat money as anybody could want or need, what is the rationale or justification for any interest….other than tradition? If price is truly determined by supply and demand, aren’t we exactly where theory says we should be – at 0 interest? Yet, does there not come a time when loan margins are so razor thin that even minuscule inflation will render a bank non-profitable? And that leverage, and ONLY leverage, can make a bank profitable in such a scenario? Should Florida bungalows be leveraged to the billion dollar mark? What is the logical stopping point? Shouldn’t a person with a reliable 50K annual income be able to borrow at negative interest rates essentially an infinite amount of of money? (Woo Hoo! all the strippers and blow I want!!!!)

      When I was a child, I remember the streets had saving and loans, and had signs that advertised both interest and loan interest in NEON signs, that is how stable interest rates were. I wonder how much leverage there was back than? I wonder how profitable banks were than, what all the financial metrics for judging banks are, and how 1960’s banks compare against 2010 banks?

      If money is “loaned” into existence (The FED “LOANS” money to banks – it doesn’t GIVE money to anyone, and the banks “loan” money to applicants) it seems to me that we are putting the tail before the dog more and more – it is JUST finance, and what useful things the money is used to make and employ people becomes less and less, and acceptable profits all come down to just taking the money and leveraging it EVEN more because actually doing something can never entail the profits of “leverage.” Of course, this just inflates assets more and more and…
      For example, whether Carrier or Ford is moving manufacturing to Mexico (I assume with loaned money), apparently both firms are profitable, but not as profitable as they could be. The US – the highest GDP, the highest inequality, and the highest unemployment….

      Every year (was the exception 2008?) GDP goes up, but satisfaction goes down.
      It was the most liquid of times, but the thirstiest of times….

      1. Jim Haygood

        ‘signs that advertised both interest and loan interest in NEON signs, that is how stable interest rates were’

        … courtesy of the now-defunct Federal Reserve Regulation Q, limiting the interest rate payable on savings accounts.

        A whole subculture of white-shoe bankers leaving at 3 pm to play golf was destroyed, when Reg Q’s demise subjected the former rate cartel to the horrors of competition. :-(

  2. TedWa

    The one thing missing in all this 11 dimensional chess game of global bankster protection is a Fed mandate to ensure wages grow along with whatever inflation they create.

  3. Jim

    Charles W. Calomiris is one of the individuals responsible for originating the idea that Fannie and Freddie caused the recent financial crisis. I believe that article appeared in a Wall Street Journal editorial sometime in Sept. of 2008.

    I also believe that Philip Mirowski mentioned Calomiris as a card-carrying member of the neo-liberal thought collective in his recent book “Never Let a Serious Crisis Go To Waste.”

    Calomiris’s concern with the evolution and development of the powers of Central Banks is probably indicative of his belief in the necessity of a powerful State to reinforce neo-liberal approved market solutions.

  4. James Kroeger

    For quite some time, I have been making the claim that The Fed could easily have bailed out the entire financial sector of the economy, by using powers it then possessed—or could have easily acquired—without ever having to ask Congress to put up a trillions dollars for the bailout.

    I argue that the whole appeal for Congressional emergency legislation was simply to give The Fed the political cover it needed; for if it had not done so…if it had executed a bailout without first securing that political cover…alarms would have gone off throughout the land and many angry fingers would have been pointed at the captains of Finance and their pals over at the Fed.

    All The Fed needed to do was simply buy up all of the toxic assets on bank (and insurance company) balance sheets with money created out of thin air with a keystroke, at a price that would make those balance sheets look great, again. But that raw power is not something they want to wield impetuously, for they know they must always be aware of the political consequences of wielding it.

    They realized it would be insane for them to simply save themselves without first terrifying the vast majority of the political class into getting their own hands dirty. This was achieved by convincing the legislative and executive branches that they must provide most of the money for the bailout.

    This had the desirable effect of getting the political class across both major parties to vocally defend the Fed’s actions with the rationalization that these very desperate measures were needed in order to prevent a nightmarish disaster that would inevitably hurt the poor and working class the most.

    It was indeed a brilliant plan.

    And they executed it perfectly, rather easily persuading the Centrist President-Elect to sign on to it before he even took office. Thus did Obama become a willing tool of the FIRE sector elites from day one.

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