From Bagehot to Bernanke and Draghi: Emergency Liquidity, Macroprudential Supervision and the Rediscovery of the Lender of Last Resort Function
September 19, 2013
Thomas C. Baxter Jr., Executive Vice President and General Counsel
Remarks at the Committee on International Monetary Law of the International Law Association Meeting, Madrid, Spain As prepared for delivery

Let me begin by thanking Banco de España for hosting this meeting of the Committee on International Monetary Law of the International Law Association, and for honoring our distinguished Vice Chairman and General Counsel of the European Central Bank, Antonio Sáinz de Vicuña. My topic today will be emergency liquidity, an especially important part of the central bank’s lender-of-last-resort (LOLR) function. In my view, the worst financial crisis since the 1930’s has led to a “re-discovery” of this critical functionality. I deliberately use the word “re-discovery” because the criticality of this LOLR function is not new. In 1873, Walter Bagehot wrote about LOLR in his classic, Lombard Street – A Description of the Money Market. We in the financial services industry seem to have forgotten the significance of the LOLR function until the Great Recession.

My remarks today find inspiration in the work and career of one of the great central bank lawyers, Antonio Sáinz de Vicuña. As many here know, Antonio started as General Counsel at the European Monetary Institute in 1994. He moved to the new European Central Bank upon its establishment. The success of the ECB was the product of many hands, including Antonio’s. It seems both natural and right to speak about the LOLR function at this event honoring Antonio, given that the Great Recession awakened an understanding of how emergency liquidity actions by central banks like the ECB can affect the greater good. Of course, such actions are possible when the central bank is advised and guided by great counsel, counsel like Antonio Sáinz de Vicuña.

Some Historical Background

The human species is obviously imperfect, a proposition that world events support on a daily basis. Among our imperfections is a tendency to conclude that significant challenges are new, and that our predecessors surely have never had to address problems like those that are presented to us. We always seem to think, and I will paraphrase Rogoff and Reinhardt here, that “this time is different”. As the financial crisis deepened during 2008, I confess that some of these thoughts were in my mind at the Federal Reserve in New York. In the darkest of crisis days, the depth and severity of our problems seemed extraordinary and unprecedented. And then I happened across Bagehot’s Lombard Street. It reminded me that the crisis may have been extraordinary, but it was surely not unprecedented.

Even today, I am amazed that a work penned more than a century before the Great Recession has such relevance. Surely the current global financial services industry has no similarity to the banking industry of Bagehot’s London, where the bankers wore green eyeshades not Google glasses, and real money was measured in millions rather than trillions.

If you also think like this, then think again. Consider this quotation from Lombard Street:

“Theory suggests, and experience proves, that in a panic the holders of the ultimate Bank reserve (whether one bank or many) should lend to all that bring good securities quickly, freely, and readily. By that policy, they allay a panic; by every other policy they intensify it.”1 

Bagehot’s central theme was about liquidity, and how the central bank must inject it during times of financial panic. I urge those of you who have not looked at Lombard Street to do so. Much of what is written continues to have application to the problems we see today. For example, Bagehot urges the central bank to lend freely into a panic, and to do so “at a very high rate of interest.”2  He explains that the reason to charge a penalty rate is to use price as a self-limiting mechanism. In Bagehot’s words, a penalty rate mitigates moral hazard and “will prevent the greatest number of applications by persons who do not require [a loan from the central bank].”3 

Bagehot also urged another core principle for central bank liquidity. He believed that central bank lending should be secured by good collateral.4  He said that “[t]he only securities which a banker, using money that he may be asked at short notice to repay, ought to touch, are those which are easily saleable and easily intelligible.”5 

Emergency Liquidity During the Great Recession

Look at the actions taken by the Federal Reserve and the ECB during the Great Recession. Let us begin with the Federal Reserve. In a speech at the National Press Club in February of 2009, Chairman Bernanke remarked that “the Federal Reserve has done, and will continue to do, everything possible within the limits of its authority to assist in restoring our nation to financial stability and economic prosperity . . . .”6  Consider just two Federal Reserve actions.

In September of 2008, the Federal Reserve Bank of New York entered into a revolving credit facility whereby it agreed to lend AIG up to $85 billion. This loan—the largest extension of credit to a single borrower in the history of mankind—was done in the manner Bagehot suggested. It was fully collateralized by unrestricted shares that AIG owned in some of its operating subsidiaries, and it was done at a penalty rate of interest.

A second example can be seen in a broad-based facility that the Fed established to inject liquidity and calm the panic that might have resulted otherwise. On March 17, 2008, the Federal Reserve introduced the Primary Dealer Credit Facility which enabled primary dealers to borrow from the central bank. Consistent with the Bagehot guidance, borrowings were all fully secured by good collateral, and interest was assessed at a penalty rate.

As for the ECB, in July of 2012, Mario Draghi, the ECB President, delivered a speech that closely tracks the formulation used by Chairman Bernanke at the National Press Club. He said “[w]ithin our mandate, the ECB is ready to do whatever it takes to preserve the Euro.”7  President Draghi then spoke about situations where “liquidity can’t flow” and taking actions that would eliminate barriers to the provision of liquidity. While a discussion of the liquidity operations of the ECB is beyond the time available for my remarks today, I think it is fair to say that the ECB’s operations have matched President Draghi’s words.

Old Bottle, New Wine

In speaking about LOLR, it seems fair to say that during the Great Recession, central banks used Bagehot’s old saw. Panic that might have arisen out of the Great Recession was calmed through central bank lending, fully secured at most central banks and done at penalty rates or on penalty terms. With that said, the Great Recession also saw changes in some of the liquidity operations. These changes came about as a result of evolving policy views and changes in the law.

One of the changes wrought during the Great Recession was the change in orientation toward risk in the financial system. In the years leading to the crisis, supervisors had spent too much time dwelling on the systemic risks that might result from the failure of an individual institution. Supervisors and central banks did not spend sufficient time thinking through the systemic risk that might result from components of the financial system operating in tandem. For example, there was insufficient attention to the subprime mortgage market, and how a problem in the subprime market might be multiplied through the dynamics of securitization. This learning led to the distinction between microprudential supervision—supervision oriented toward a single bank or holding company—and macroprudential supervision—supervision oriented toward systemic risk across the financial system.

The newfound focus on macroprudential supervision also influenced legal developments with respect to emergency lending facilities. Section 13 (3) of the Federal Reserve Act, for example, was amended by the Dodd Frank Act in a manner that might be considered “macroprudential”. Emergency lending under Section 13 (3) to a non-bank (the statute uses the phrase “individual, partnership and corporation”) was no longer permissible to save a non-bank from bankruptcy, or to take assets off the balance sheet of a non-bank. Consequently, emergency lending like the lending done by the Federal Reserve to AIG and to Bear Stearns would no longer be authorized.

On the other hand, lending pursuant to broad based facilities, done to inject liquidity into a market, would continue to be authorized under Section 13 (3). Consequently, broad based facilities like the Primary Dealer Credit Facility would continue to be permitted for what might be considered “macroprudential” issues.

Another change from the time of Bagehot relates to how the public views emergency liquidity assistance from the central bank. During the Great Recession, the public came to view the proceeds of emergency lending as “taxpayer moneys”. There is no similar conception in Lombard Street, which looks at the proceeds of loans from the Bank of England as representing an obligation that needed to be repaid, and clearly distinct and separate from the assets of the government.

In my view, this change in the way the public looks at central bank lending has some important consequences. First, it provides incentives for the lending central bank to pay close attention to the risk of nonpayment. If a borrower fails to repay the central bank, this represents a problem much greater than a bad debt that produces a loan loss for a lender. Instead, the failure to repay rises to a more culpable malfeasance, namely the failure to be a good steward of public funds. The change in conception, at least from my perspective, has caused central banks, including the Federal Reserve, to become ever more sensitive to the risk of financial loss. This move toward risk aversion might conflict with the policy imperative that Bagehot articulated, namely a massive liquidity injection to calm a growing financial panic. The policy imperative makes liberal lending the first priority, and lending loss risk aversion secondary. Of course, as the AIG and Bear Stearns cases demonstrate, it is possible to achieve both objectives.

Second, the change in the way the public views lending raises “fairness” considerations that also put the central bank in a rather indelicate position. For example, during the Great Recession, many individual borrowers facing foreclosure on their mortgages wondered why they were not rescued, while corporate borrowers that created systemic risk, like AIG and Bear Stearns, were rescued. Of course, the answer to this fairness question takes us back to Bagehot. He said that the central bank lends “to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they waited a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money.”8  The idea is to calm the panic that causes people to run on financial intermediaries with central bank lending to those financial intermediaries. The focus is on a special class — financial intermediaries—where the loan proceeds are needed to calm the financial panic, which, as occurred during the Great Recession, can adversely affect the broader economy and thus millions of individuals beyond just Wall Street.

The last change that is noteworthy relates to one of the functions performed by central bank lawyers. In the quotations above from Chairman Bernanke and President Draghi, there are references to doing whatever it takes within the scope of the legal authority or mandate. Central banks are created by and exist under law. The interpretation of those authorities has led central bank lawyers to address new situations arising from changes in the delivery of financial services (for example, new intermediaries like investment banks and insurance companies), and also to new and different methods that can be used to inject emergency liquidity (like the special purpose vehicle).

In the Great Recession, the Federal Reserve needed to address the situation of the investment banks, which borrowed short term in the repo market but had to fund longer term liabilities. Because the investment banks were not organized as traditional banks, the Federal Reserve had to look to nonbank legal authority to inject needed liquidity. We found such authority in Section 13 (3). But we also found authority to use current financing techniques that enabled the lender to better manage and control the risk in such lending. At the Federal Reserve, we found authority to create limited liability companies which could use the proceeds of emergency lending to acquire certain assets, effectively injecting liquidity but also better controlling and managing the assets that protected and compensated the taxpayer.


Moments like these, where we gather together to share our common interests in monetary law and to celebrate the career of a great monetary lawyer, also provide time for reflection. In reflecting on the Great Recession and the career of Antonio, the re-discovery of the critical LOLR function seems to be the perfect topic. The central bank’s LOLR function provides the means to calm financial panic by injecting liquidity for the greater good. The LOLR function is performed using the advice, talent and skill of the central bank lawyer.

Thank you very much, Antonio, for your leadership and inspiration, and thank you ladies and gentlemen for your kind attention.


1Walter Bagehot, Lombard Street – A Description of the Money Market, at p. 78 (Seven Treasures Public. 2009).

2Id. at 88.

2Id. at 88.

3Id. at 88.

4Id. at 88.

5Id. at 108.

6National Press Club, February 18, 2009.

7Mario Draghi, Speech at the Global Investment Conference in London, July 26, 2012.

8Bagehot, at 32.

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