Bank Of England As A Last Resort Lender Finance Essay

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A lender of last resort within the United Kingdom is essential in order to preserve a balanced financial system. The Bank of England developed into a central bank by adopting the underlying principles of a lender of last resort. The bank was established in 1694 and immediately two years after its creation it experienced its first bank run. It behaved as a lender of last resort within its early stages as a bank throughout the 18th Century. [1] The emergence of a globalized financial world, via industrialization, compelled the Bank of England to strengthen its position in the assistance of global crises and consequently turn into a lender of last resort. The discount operations that were conducted by the Bank of England in its early stages, in order to prevent financial panics, helped in the development of its present status as the centre of financial assistance for the overall economy. [2] The Bank of England attained full responsibility of the monetary policies in 1997. [3] This is largely due to the government innovation of implementing regulation for the welfare economy.

The classical view of the need for a lender of last resort arose from banking panics which were threatening the money stock and consequently the overall economy. The lender of last resort would provide the necessary funds by the process of discount window for the higher power money needed in order to prevent the crisis. Henry Thornton and Walter Bagehot were able to determine the necessary requirements that a lender of last resort would have to follow in England in order to penalize the financial institutions in a calamity. The central bank would support these institutions in the case of a panic, but would have to issue a "penalty rate to illiquid but solvent Banks." [4] Alternatively, while this view is held by many economists, others like Charles Goodhart believe that a lender of last resort should also aim to help insolvent financial institutions. [5] The central bank should assist these insolvent banks temporarily. Thornton and Bagehot disagreed with the notion of lending to an insolvent bank because it would lead to future risk-loving behaviour by the banks. Bagehot stated, "Any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank". [6] Bagehot was well aware of the dangers and risks in lending to a risky bank and its implications of future decisions made by the bank in the economy. Robert Solow believes that the central bank should help insolvent banks, because a bank failure depreciates the overall stamina of the economy and its financial system. If a major bank fails, this might produce a domino effect for other banks and hence it is the central bank's responsibility to prevent this from taking place. Allan Meltzer contradicts these views and disputes that banks should make allowances for financial institutions which are insolvent to fail, because if banks know that they could attain help whenever they are in a crisis, they would do so for their own selfish benefit and take greater risks in the future. [7] The notion of a free market dictates less government intervention and the creation of a free system "laissez faire" in which a bank panic will not occur, because banks would make risky investments which would jeopardize their institutions and the overall market structure.

Bank failures are caused by both internal and external factors. Internal factors within the bank are due to irregularities and mismanagement by personnel. External factors that affect the bank are changes in the price level and relative prices (e.g. oil prices). [8] These factors can rendered a bank as insolvent and hence depositors would try to leave this bank by cashing out their deposits, leading to a bank run. The lender of last resort can stop the threat of insolvency by supplying financial aid to the Bank.

Bagehot agreed with Thornton's view that the responsibility of a central bank during a panic is to be a lender of last resort, but also additionally added four principles for a central bank to follow:

Lend, but at a penalty rate; [9] 

Make clear in advance the Bank's readiness to lend freely; [10] 

Accommodate anyone with good collateral; [11] 

Prevent illiquid but solvent Banks from failing. [12] 

These four principles are followed by lenders of last resort today and are the prerequisite of central banks worldwide. They guarantee financial protection for both the economy and banks by stating the actions that have to be taking towards banks which are in need of financial aid. Henry Thornton's concept of the central bank as a lender of last resort is necessary in order to impede the spill over damages created by financial crisis to other sectors of the economy.

In "Myths about the Lender of Last Resort", Goodhart points out the lack of present problems in Thornton's era that central banks face today. Thornton's view of how a lender of last resort should behave was based on 19th century usury laws against banks. Goodhart disagrees with the view of previous classical economists who believed that it was possible to differentiate between illiquidity and insolvency, and the lender of last resort should only concentrate on repairing illiquidity. [13] In the present time, banks are now able to regulate their own liquidity by using wholesale money markets, which were not the case when classical economists presented their justifications of separating illiquidity and insolvency. A lender of last resort has to protect the overall financial system if there is a crash of illiquidity. Goodhart states, "There are some exceptions to this rule, that nowadays illiquidity implies at least a suspicion of insolvency." [14] The reputation of a bank changes instantaneously once the public becomes aware that their bank needs money from the central bank. It could inadvertently create a major loss for the bank when it is borrowing from the central bank due to the suspicion of the public and the fear they may have towards losing their money.

Central banks have actually plummeted due to the fact that they have become the lender of last resort for financial institutions. Goodhart states, "CBs in some countries, mainly in Latin America, have actually become technically insolvent as a result of losses incurred on loans in support of the domestic financial system." [15] The losses of these financial institutions became a major burden for the overall economy, which could not be supported by their central bank alone. "He who pays the piper call the tunes. In large-scale, systemic domestic cases, the government pays the piper." [16] Goodhart states this, because there has to be a cooperative effort between the central bank and the government in order to maintain control of the financial sector, because in the long run, the government will have to "pay the piper". The government has a natural responsibility for the welfare of its society and its citizens.

Goodhart also considers, "that moral hazard is everywhere and at all times a major consideration" [17] a myth. This is due to the fact that within the financial structure, banks are able to borrow even when they do not face a financial crisis. The lender of last resort is used whenever there is a need because failing financial institutions are going to have a major economic impact in the overall economy. The tax payer bears the burden with the final bill nowadays if a financial institution requires the central bank to act as a lender of last resort. This is why many economists today have the notion that a lender of last resort should be eliminated, because banks would ultimately pass the burden to the central bank which would then inflict the load on the public. This would make banks take riskier decisions when investing with the money of the public. Goodhart also regards the possibility of managing without a lender of last resort a myth. [18] The government has a responsibility to the citizens and hence their banks from not collapsing. The lender of last resort is essential in order to avoid bank failures.

The notion that a bank is too big to fail was supported by Goodhart in 1999, conversely the United Kingdom in the 1990's suffered a crisis created by small banks. [19] The Bank of England had to intervene and prevent this crisis from expanding to other sectors of the economy. The use of interbank lending within banks has cause a major change in the role of the central bank to let a single bank fail, even if it is a small bank. The use of interbank lending leads to a domino effect that could potentially create a higher crisis for the financial sector of the economy. This could be avoided by the central bank intervening in the first place when the catastrophe could have been avoided.

Inter-banking occurs because some banks required immediate funds in order to have the necessary liquidity and also to assure that they meet the requirements of safety regulations. In 2007, there was a liquidity crises in which, "Developments in the pricing of overnight loans suggest that the financial crisis has widened the difference between credit spreads paid for overnight funds by the most active (roughly the largest) versus the least active (roughly the smallest) banks." [20] In the 2007 interbank crises, banks were reluctant to trust the balance sheets of other banks and did not lend to these banks. The interbank loans were significantly high and so the central bank had to assist these banks by implementing liquidity and was able to "rescue" them. The central bank acted as a lender of last resort, which unfortunately increased the central bank's liabilities. The idea of interbank is to minimize credit publicity and allow for easier funds transfers to occur within banks. The US subprime mortgage crises created a chain of events that was felt all over the world by central banks. The crises of 2007 created tensions among central banks, because they didn't know where the liquidity needed to be implemented in order to prevent the crisis from spreading.

In "An Enquiry into the Nature and Effects of the Paper Credit of Great Britain", Henry Thornton examines the necessity of a central bank as a lender of last resort. He disagreed with Adam Smith's "Inquiry into the Nature and Causes of the Wealth of Nations", which influenced the policy of the Bank of England to minimize their Banknote issue in 1793. [21] Bottom of Form This would reduce the overall effect of the activities of banks which would further lead them to insolvency. He advocated the dependency of the government to the central bank vice versa:

"The Bank of England is quite independent of the executive government…It is the only lender in the country on a large scale; the government is the only borrower on a scale equally extended; and the two parties, like two wholesale traders in a town, the one the only great buyer, and the other the only great seller of the same article, naturally deal much with each other, and have comparatively small transactions with those who carry on only a more contracted business." [22] 

Thornton envisioned the Bank of England as a lender of last resort and its relationship with the government. He foresaw that in order to reduce financial crises, both the central Bank and the government should work hand in hand. In order to prevent the emergence of financial panics, he foresaw the necessity of a central bank as a lender of last resort to financial institutions. Thornton believed that one of the major apprehensions of the central bank was to look after the intensity of the total money stock.

Insolvent banks can greatly have a negative influence on the financial market. Central banks are not always capable of distinguishing between solvent and insolvent banks due to the time restrictions in which banks learn they need the lender of last resort and central banks have to make a decision whether to lend. The Diamond and Dybvig model was the first model able to show the rational behind bank runs. An external event in which a bank run would initially commence is described as "sunspots" in this model. [23] If depositors have any indication that there are internal problems within the bank, they will quickly withdraw from the bank and this would lead to a bank run. The confidence of the depositors would ultimately decide a run on a bank.

There is empirical evidence which suggests that failing banks are not likely to be liquidated, but rather they will be helped by the input of more capital. In "Burden sharing in a Banking crisis in Europe", Both Goodhart and Schoenmaker were able to collect substantial evidence which suggests that Banks which were failing were more likely to be rescued financially rather than being liquidated. [24] This is largely due to fact that these Banks were interconnected with many other businesses and if they were to fail, the financial calamity in the overall society would have been devastated for the economy.

Current global problems indicate that in the future an international lender of last resort will be crucial. As the world becomes smaller due to technology and more firms are looking internationally for profits, an international lender of last resort will be inevitable.

Goodhart ascertains that it is a myth that IMF cannot function as an International lender of last resort. He compares a bank turning to their central bank to acquire money as the same as a national government turning to the IMF in order to prevent a widespread catastrophe. The international relations the IMF has, makes it a perfect candidate for an international lender of last resort. "The IMF has more capital, and could sustain larger losses. Moreover, the IMF has the most senior ranking as creditor, so losses are perhaps even less likely than in the case of a domestic CB." [25] The demised of the IMF would not lead to a laissez-faire economy, but instead the necessity of "the weak will look to the strong for support." [26] The housing bubble in the USA had global implications for financial firms in Europe and abroad. In 2003, "Nordic countries agreed on a multinational coordination model for the performance of the LLR function vis-à-vis a multinational Banking group with operations in two or more countries." [27] This suggests that countries have already started to think of the implications of having a lender of last resort but on an international level. In order to prevent future global crises from occurring, an international lender of last resort will be a requirement.

On 14 September 2007, there was a bank run on Northern Rock due to the fact that Northern Rock asked the Bank of England for financial support. [28] The Bank of England acted as a "lender of last resort" towards Northern Rock. [29] "The Chancellor of the Exchequer has today authorised the Bank of England to provide a liquidity support facility to Northern Rock against appropriate collateral and at an interest rate premium." [30] There are many expenses associated with being a lender of last resort, but the Bank of England has to assume responsibility for the overall welfare of the economy. Banks and the Bank of England have a main responsibility to uphold and that is to serve the public's best interest. The present actions that have been committed by banks today suggest that banks have deviated from this idea. Perhaps instead of being a lender of last resort, the Bank of England can change their policy to a lender of first resort. In the USA, "The Federal Reserve proceeded to transform itself from a lender of last resort into the lender of first resort, thereby pre-empting application of prompt corrective action rules." [31] A lender of last resort is needed in order to maintain a healthy welfare nation.