A Bank of England official has defended the safety net it used in response to the financial crisis.
Andrew Hauser, executive director of banking, payments and financial resilience, said the Bank’s lender-of-last-resort (LOLR) operations during the 2007 and 2008 financial crises “helped prevent global economic and financial meltdown.”
The Bank first lent cash to Northern Rock in 2007 and later lent money to a wide-variety of much bigger banks in September 2008.
The Bank has acted as lender-of-last-resort (LOLR) since 1866, when Overend and Gurney, a large financial company, was allowed to fail. The Bank lent money to other banks, helping to stem a widespread crisis. It led to the publication of Lombard Street, an influential book on central banking by Walter Bagehot, who has a column named after him in the The Economist.
“Without an effective LOLR framework, economies cannot hope to foster strong and sustainable growth over the long run,” Hauser told an audience in Washington today.
“Countries lacking such backstops are likely to sustain large-scale, and preventable, economic damage. So the risk of central banks having ‘too little’ scope to carry out LOLR is real.”
However, he went on to say that there were reasons why the Bank should avoid too much LOLR action.
“One strand of this debate is led by those who feel that central banks lent ‘too much’, too often or too freely during the crisis, using public money – so the allegations go – to support institutions of dubious solvency, sometimes in secret, protecting bankers from their own mistakes, and thereby stoking moral hazard for the future,” Hauser said.
“But another strand in the debate draws the opposite conclusion from the crisis – focusing on the risk that central banks might lend ‘too little’, too rarely or too late, amplifying what might begin as short-term liquidity shortages into deeper or more persistent solvency concerns, and subsequently causing financial institutions to over-insure, reducing their capacity to lend.”
“The public has a legitimate interest in avoiding ‘too much’ LOLR. We cannot afford for financial institutions to view liquidity support as a substitute for prudent financial management: central banks must not be ‘lenders of first resort’. And lending to institutions that are in need of capital rather than liquidity is the wrong solution,” he said.
Hauser said the Bank had improved its LOLR protocols since the financial crisis. The Bank, he said, was more transparent about how it would lend in future. He also said it can now lend to certain institutions other than just banks, such as central counter parties (CCPs).
Regulators have placed massive responsibility for the financial system’s safety on the shoulders of CCPs such as LCH Clearnet since the financial crisis.