PITY POOR MERVYN KING. The governor of the Bank of England has come under fire from all sides. First, at the onset of this summer’s credit crunch, he made himself unpopular by being less accommodating than his peers in Europe and the U.S. Then, after King agreed to provide emergency funding to the stricken Northern Rock, Britain’s fifth-largest mortgage lender, he was accused of fostering moral hazard. This assistance inadvertently sparked the first bank run in England in over a century. And most recently, King was forced into an embarrassing about-face on his previously tough stance by agreeing to extend loans to banks for longer periods against lower-quality collateral. Meanwhile, the Bank of England’s loans to Northern Rock keep growing.
All this goes to show that the role of the central bank during times of panic is more difficult in practice than it might appear in theory. The notion that the bank should act promptly in a crisis was first clearly articulated in the late 18th century. In 1793, when the British canal mania came to an end, a number of banks in Newcastle (Northern Rock’s hometown) found themselves in trouble. These banks had rich partners, but they couldn’t convert their property into cash in time to meet the demands of depositors. Rather than help out, the bank panicked and restricted its note issue, thereby worsening the crisis.
The timidity of the Old Lady of Threadneedle Street, as the bank is known, was later attacked by banker Sir Francis Baring, who in a pamphlet (recently reprinted in a collection of essays, Lender of Last Resort, edited by Forrest Capie and Geoffrey Wood) argued that the bank was the “dernier resort” of other banks. During a panic its directors should lend “almost to their last guinea” to prevent the circulation of notes from contracting and business from freezing up. “Credit,” wrote Baring, “ought never to be subject to convulsions.”
No one would disagree with that. But even early on, it was recognized that a lender of last resort should act circumspectly. Baring’s contemporary, the banker Henry Thornton, warned that the bank shouldn’t “relieve every distress which the rashness of the country banks may bring upon them.” In particular, it should not assist those guilty of “misconduct.” The essayist Walter Bagehot, in his classic work Lombard Street (1873), stipulated still more conditions. He believed the bank should lend freely during a crisis but only to solvent institutions, for short periods, at a high rate and against first-class security. More recently, Anna Schwartz, an economist with the U.S.'s National Bureau of Economic Research, argued that the central bank should act as lender of last resort only when contagion threatens the credit system as a whole.
It is largely a matter of judgment how a central bank complies with these principles. In a panic, distinguishing between a bank that cannot meet payments due to temporary illiquidity and one at risk of insolvency can be difficult. How does one define misconduct? What constitutes good security for central bank loans? What is the difference between a real crisis and what Schwartz calls a “pseudo crisis”?
These are old questions, but they have resurfaced with force in the case of Northern Rock. It was, by all accounts, well managed. But in recent years it expanded rapidly and provided mortgages that far exceeded home values at a time when U.K. house prices were fully extended. Although it complied with banking regulations, Northern Rock suffered from an extreme mismatch of deposits and liabilities. It was also highly leveraged.
Some might deem Northern Rock’s management to have been guilty of misconduct in the nonfraudulent sense, in which case the Bank of England should have let it fail as a caution to others. Yet many believe that Northern Rock is an innocent victim of the global credit crunch. It’s also not clear what would have happened had Northern Rock failed. Given its relatively small size, the bank’s closure should have posed little threat to the stability of the financial system. But there might well have been a run on other U.K. mortgage lenders that also borrow heavily in the money markets and securitize their loans. The contagion could have spread further and become far harder to contain. Whatever action King took was open to criticism. He found himself caught between a rock and a hard place.
The main argument against a central bank bailing out all and sundry during a crisis comes from the need to restrain moral hazard. But even here there is little agreement among policymakers. Former U.S. Treasury secretary Lawrence Summers plays down fears that a central bank, acting as lender of last resort, actually encourages reckless behavior. Summers recently attacked the “moral hazard fundamentalists” who would deepen a crisis by failing to forestall it.
Yet fear of moral hazard is as old as the notion of a lender of last resort. In the 19th century, Thomson Hankey, a former Bank of England governor, attacked Bagehot for expounding “the most mischievous doctrine ever broached in the monetary or banking world in this country.” Shortly before throwing Northern Rock a lifeline, King publicly warned that the “provision of liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behavior. That encourages excessive risk-taking and sows the seeds of a future crisis.” King added that such a provision “penalizes those financial institutions that sat out the dance, encourages herd behavior and increases the intensity of future crises.”
It’s possible that the specter of Alan Greenspan flashed in the governor’s mind as he penned these words. Not that these issues are raised in the former Federal Reserve Board chairman’s memoir, The Age of Turbulence. Yet arguably no central banker in history has done more to foster moral hazard.
In his last years at the Fed, Greenspan was guided by a strong precautionary principle in his approach to potential crises: That one should act to deflect a great evil even if there is only a small chance of its occurring.
Greenspan slashed interest rates after Russia reneged on its debts in the summer of 1998 and hedge fund Long-Term Capital Management started to flounder because, he writes, of a “small but real risk that the default might disrupt financial markets enough to severely affect the United States.” The Fed chairman provided liquidity again at the turn of the century, fearing the “millennium bug” would have “dire” consequences. Likewise, concern about potential deflation after the dot-com bust led him to keep real interest rates negative long after the economy had recovered.
Bagehot warned that the central bank’s power to provide liquidity “is one excessively liable to abuse. It should only be used in rare and exceptional cases.” Greenspan didn’t heed this warning. Instead, his repeated application of the precautionary principle encouraged countless financial institutions to follow Northern Rock’s example: taking big risks to boost returns on the assumption that it would always have access to cheap funds. Now King and other central bankers around the world must pick up the pieces.
