What has the financial crisis meant for the LOLR function as practiced by the Bank of England, Federal

Reserve System and the European Central Bank. Central banks are often responsible for many roles in a countries economy during times of economic prosperity. During a financial crisis, a period of time where the value of institutions and assets decrease rapidly, central banks are tasked with additional responsibilities such as becoming the lender of last resort (LoLR). The subprime mortgage crisis of 2007 made the task of the central bank particularly difficult because the majority of institutions hurt by the crisis were banks and financial institutions which in turn led to a rise in the interbank lending rate and a shortage of credit because banks were no longer comfortable lending to each other. Central banks were required to intervene and provide liquidity to banks via the LoLR function. This essay aims to look at how the Federal Reserve System (FRS), the Bank of England (BoE), and the European Central Bank (ECB) adjusted their roles as being the LOLR to compensate and ultimately deal with the unique crisis faced. It also aims touch upon the role of the ECB during the more recent sovereign debt crisis. The principles of the LoLR was originally suggested by Bagehot in his book , Lombard street (1873), where he explained how the central bank should have acted in response to the Overend and Gurney crisis. His principles dictated that central banks should Lend freely to borrowers, but only at a high interest rate relative to pre-crisis interest rates and only to borrowers who could provide good collateral (collateral that would be accepted pre-crisis), and that therefore, any financial entities without good collateral should be allowed to fail. Finally he stated that assets should be valued between pre-crisis and crisis prices. Although relevant at the time,

Bagehots principles should be thought of as being more of a guide than a set of rules. This is because of changes to the economic system since its inceptionfor example the emergence of financial entities thought of as being too big to fail and the increase in interconnection within the economic system .As stated in (Chadha, Holly 2011) if one followed Bagehots principles too narrowly there would be no scope for bailout. The FRS was among the first central banks to face the crisis and generally took an aggressive approach to dealing with it. Initially the Federal Reserve utilized a more traditional approach by attempting to inject liquidity using its open market operations, and encouraging banks to use the discount window by lowering interest rates. This was perhaps the first instance where the FRS deviated from how it had practiced the lender the last resort function prior to the financial crisis. However, the stigma associated with using the discount window, i.e. any bank using it would signal that it was having liquidity problems, hindered the success of the policy. Additionally, the FSR did not accept mortgage backed securities as collateral at the time which further crippled the effectiveness of a reduction in rates. Thus, the FRS was forced to employ other tools beyond traditional LOLR methods. One such tool was the Term Auction Facility (TAF), which allowed for longer term lending and provided liquidity to financial institutions lacking it the while removing the stigma associated with the discount window. Furthermore, the TAF allowed banks borrow on mortgage related assets unlike previous FRS policies that required more valuable collateral. Similar actions were taken by BoE and the ECB into their respective economies. Ongoing legislation like the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF) - which was

originally used to help Bear Sterns and - further exemplified the changes made by the FRS by allowing banks to borrow on a larger range of collateral that had been previously accepted. Generally the FRS was viewed to have responded rapidly in terms of historical comparison to the crisis (Bernanke 2008). In a speech in 2012 Bernanke later argued that such actions had to be taken because bailouts, although not normally endorsed by the traditional LoLR function, were better the alternative. Debatably the speed at which the FRS reacted could indicate movement towards a more efficient LoLR function, even if some of the firms that were lent to had bad collateral. In contrast, the BoE adopted a more passive approach to dealing with the crisis by choosing to behave like more like the LoLR first suggested by Bagehot. Notably the BoE delayed its reaction toward the collapse of northern rock-then the fifth largest mortgage lender in the UK. It also chose to impose institutions who wished to access emergency funds with a penalty rate, unlike the FRS. Additionally, it refused to accept any collateral aside from gilts, as identified in (Chadha, Holly 2011) a bank that can put up a riskless asset should have no problem obtaining as much liquidity as it needs.(King 2007) attempts to justify such rigid lending by stating that it was in used in an attempt to curb moral hazard. It may have also been caused, in part, by a lack of co-ordination between HM Treasury, the Financial Services Authority (FSA), and the BoE. Delays caused by lack of co-ordination have subsequently been reduced by the abolishment of the FSA leading to the BoE becoming a more efficient LoLR. However, failing financial markets forced the BoE to abandon its stance on being as a reserved LoLR and adopt a more active role in order to deal with the financial crisis. In December 2007

the BoE began to accept a wider range of collateral ,including mortgage backed assets , as part of a coordinated effort by the BoE, FRS , ECB , Royal Bank of Canada (RBC) , and the Swiss National Bank (SNB) to increase liquidity on a global scale. It also removed the penalty rate, as well as cutting interest rates, in order to make borrowing cheaper. Furthermore, it introduced the Special Liquidity Scheme (SLS) which let banks swap their mortgage backed securities for UK
Treasury Bills in order to increase the amount of tradable liquid assets held by banks.

The ECB presents a very unique situation from that of the BoE or the FRS because of the limitations placed upon it by the statute of the Euro system Central Banks that prohibit the ECB from acting as a LoLR the way the FRS and BoE do .Nevertheless, the ECB reacted swiftly during the early stages of the crisis by taking measures to increase the amount of liquidity available. Within a few hours of the crisis emerging it provided 94.8 billion euros. In October 2008 it reduced its interest rate by 50 basis points in a synchronized move by the FRS, BoE, ECB, RBC,
Sveriges Riksbank (SR), and SNB and by May 2009 its interest rate had fallen to 1%. In October 2008

it also implemented a number of measures known as enhanced credit support which increased the range of assets that were accepted by the ECB as collateral as well as offering longer term financing for 3 and 6 month longer-term refinancing operations and would therefore provide increased liquidity during the time frame.

The more recent sovereign debt crisis and the increase in instability of EU member nations such as Greece and Portugal led the EU to introduce the Securities Markets Program (SMP) which was aimed at allowing the ECB to intervene in specific financial markets (Greece, Portugal, Ireland, Spain, and Italy) to ensure liquidity. Regardless, it cannot be denied that the ECB

adopted stricter policy in dealing with the sovereign debt crisis than it did with the subprime crisis. From May 2010 to August 2011 the ECB reduced its balance sheet by almost 200 Billion Euro (De Grauwe 2011) - A stark contrast from the stance it took when facing the repercussions of the sub-prime crisis. It is clear that the ECBs limitations inhibit its ability to deal with the crisis, for example it is the only of the three banks not to have begun quantitative easing although it possible to argue that the ECBs unusually fast response meant that quantitative easing was not needed. Currently it is possible the ECB is unwilling to be the LoLR even though some argue that it must (Krugman 2011).

The recent financial Crisis has required central banks to sufficiently evaluate their approach towards being LoLR while improving the tools banks use to do so. All three banks have expanded the types of accepted collateral as well as making borrowing cheaper. This has sometimes even been done in coordination with other banks to trigger a more widespread effect. The creation of Additional tools , such as the TAF, has given central banks more versatility in being the LoLR .However, it is evident that the FRS and the ECB reacted faster and lent more freely than the BoE did. Notably , the FRS provided liquidity options for bear sterns during the crisis whereas the BoE provided very little assistance to Northern Rock. Furthermore, The FRS lowered the discount window and accepted mortgage backed collateral before the BoE did. Nonetheless all three banks had to substantially evaluate their stance as being LOLR in order to cope with the crisis.

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