The Lender of Last Resort, 21st Century Edition

a series of new publications examines lending to troubled institutions

Dissecting financial crisis responses

Last week, the Yale Program on Financial Stability (YPFS) published Volume 7, Issue 1 of the Journal of Financial Crises. This one is close to my heart, as it comprises our series of case studies—and survey thereof—on what we’ve termed ad hoc emergency lending. The keystone piece is Ad Hoc Emergency Lending in the 21st Century, with Steven Kelly, Greg Feldberg, and Andrew Metrick (see bios here).

As many readers will know, the work of YPFS involves essentially three steps: (1) identify common tools used to respond to financial crises; (2) review selected case studies in which those tools were used; and (3) analyze best practices and caution areas for future policymakers in using those tools. The tools and case study universe come from a seminal paper by Andrew Metrick and Paul Schmelzing, which catalogues all financial crisis interventions since 1257 AD. For more on this and the way YPFS thinks about financial crises and interventions, see my earlier note on diagnosing financial crises.

You can see the various different case studies organized by intervention tool (e.g., account guarantees, capital injections, swap lines, etc.) on the New Bagehot platform, here, where we’ve compiled hundreds of case studies and thousands of pages of documentation on financial crisis interventions, from capital injections in Napoleonic France to COVID-era currency swap lines in Mongolia.

The Lender of Last Resort, targeted

Emergency lending is one of the most potent and most commonly used tools to respond to financial crises. It is often the tip of the spear—the tourniquet of financial crisis triage: emergency lending may not do the ultimate resolution and rebuilding, but it’s often the first intervention. It stops the bleeding, buying time for complex surgery or transfusions. YPFS has previously examined what we call broad-based emergency liquidity, as well as market-based emergency liquidity (here and here). We defined the former as lending that is available to any eligible institutions (think the Fed’s discount window, or other Lombard facilities), and the latter as lending that is meant to support particular markets (think lending to support the commercial paper market).

But this excludes one of the most important, controversial, and difficult types of lending: bespoke lending for specific firms. These are the Bear Stearns of the world, the Lehman Brothers, the Credit Suisse. It is exactly this—what we term ad hoc emergency lending (AHEL)—that we’ve just analyzed and published last week.

AHEL of a ride: upshots from the review

This project took two years, hundreds of pages, thousands of hours, countless interviews, and an incredible team to complete. I was honored to be a part of it, and to work with my incredible co-authors, from whom I’ve learned so much. I would encourage all interested parties to read our survey of AHEL cases in the 21st century; it’s not long, and we hope it’s quite tractable. Here’s the paper’s abstract:

This paper surveys 22 case studies of 21st century instances when financial crisis-fighters implemented ad hoc emergency liquidity (AHEL) interventions, interventions designed to provide liquidity to a troubled institution that the authorities believe is systemically important. While emergency liquidity support is often introduced with the real or communicated intention of preventing illiquidity from leading to insolvency, the liquidity crisis should instead be viewed as the manifestation of the market’s assessing the firm as nonviable as a going concern. For that reason, authorities should provide AHEL assistance only to institutions that they have deemed viable or that they have committed to make viable through additional interventions, most commonly through a government capital injection or merger with a stronger institution. Despite AHEL assistance, which the authorities in several cases sized to meet all potential funding outflows from the troubled firms, in no cases did liquidity provision alone prove a “cure” to the run on the institution. Crisis-fighters also should not use the terms of an AHEL intervention to manage moral hazard. Moral hazard can be addressed in the more structural policy responses that will need to follow AHEL assistance. AHEL programs should focus on providing sufficient liquidity to get the institution through its acute crisis phase.

I’ll highlight here some features I found particularly interesting.

AHEL interventions are very common. Even limiting ourselves to the 21st century, and even after landmark legislation in the US significantly curtailed AHEL interventions post-Global Financial Crisis, AHEL interventions were often central to the biggest financial crises and the biggest institutions (e.g., Bear Stearns, Credit Suisse, Northern Rock, all that chaos in Cyprus, and yes, even Lehman¹, just to name a few).

Actually, it is about solvency. This is one of the key contributions to the literature in my view. While, yes, it is possible that a bank run occurs because of pure liquidity challenges, we find that almost never happens in the ad hoc setting. The run is symptomatic of fundamental solvency concerns. As my co-author Steven Kelly noted in his summary of the paper: “death to the myth of the ‘illiquid but solvent’ bank that needs a rescue.”

Moral hazard is better addressed elsewhere. We are not suggesting that authorities shouldn’t be concerned about moral hazard; they should. But we find that AHEL interventions are used as bridges to more permanent solutions, and punitive terms for the AHEL often end up, counterintuitively, making those other solutions more difficult and/or expensive. For example, in a few cases, authorities tried charging punitively high interest rates to punish the bank, and then realized those interest payments were eroding the bank’s capital, which they were replacing.

Creative thinking about balance sheet protection. Lenders, mostly central banks, are often required by law or internal regulation to lend against collateral, like tradable securities and loans that the central bank can easily value (there is usually a published list of acceptable collateral for standing broad-based lending facilities). Yet it is precisely the lack of eligible collateral that creates the need for an AHEL intervention in the first place: if the bank had sufficient everyday collateral eligible for a Lombard facility, it wouldn’t need an AHEL. As a result, lenders had to get creative, using fiscal guarantees, recourse, forthcoming interventions (like capital injections), and loss-sharing arrangements to limit their risks.

Political economy and the fiscal realities of monetary lending. Of particular relevance to a common theme of this site is the political economy of AHEL interventions. My priors on this were that nearly every lender would be a central bank. I was wrong. In many cases non-central bank lenders were involved, and in four of 22, they were the primary lender. Moreover, fiscal guarantees of central bank lending were very common, occurring roughly a third of the time. This has interesting implications for political economy and central bank independence. I have written about this in the European setting in a Yale blog.

A casual observation is that one can draw a sort of bell-shaped curve, where the y-axis represents something like “autonomous central bank lending as share of total lending,” and the x-axis represents size of lending relative to the economy or banking system. At the very left end, where lending is very small, there can be no central bank involvement at all—this is where we see banking “self-help” interventions or industry loans. In the middle, we see nearly 100% autonomous central bank lending—this is the vast majority of cases in practice. In the far right, the lending gets too large for a central bank to conduct independently, owing to legal or political constraints, and it ends up being a largely fiscal operation, with the central bank taking low or very little counterparty risk itself. This is the subject of ongoing personal research.

Associated pieces

There’s a lot more to be said about AHEL, but it’s all said in the paper, so I’ll leave it here for now. I will highlight the list of cases, some of which authored by yours truly, in case of further interest, all of which can be accessed here:

Source: Ad Hoc Emergency Lending in the 21st Century

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This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.

1. Well, a part of it.