Distinguished Lecture on Economics in Government: Central Banking and Systemic Risks in Capital Markets

On several occasions since 1970, the Federal Reserve has intervened to help prevent or delay the failure of a large individual commercial bank. It has typically not played a similar role with respect to smaller banks. Moreover, in three instances, the Federal Reserve has intervened to rescue capital market institutions other than banks. These actions have been criticized as inconsistent with the responsibilities of a central bank, which have traditionally been defined to include the maintenance of the monetary base (gold, currency, or bank reserves) and control over the growth rate of the money supply. The central bank has also been perceived as the ultimate source of liquidity for the financial system as a whole. Thus, in time of financial crises, the central bank was to be the "lender of last resort." It should lend generously to other banks faced with a sudden public demand for liquidity although it should provide funds at a penalty interest rate. This traditional view of the central bank's last resort lending function is primarily the product of 19th century thinking in Great Britain. The term "lender of last resort" was apparently first used by Sir Francis Baring (1797) when he referred to the Bank of England as the "dernier resort," the source of liquidity for all banks in a period of crises. The first full treatment of the idea was provided by Henry Thornton in testimony before Parliament and in public speeches, but his comprehensive exposition of the last resort lending function appeared in 1802. However, when the subject arises among economists, the name that comes to mind most readily is that of Walter Bagehot. His definitive analysis and recommendations were presented in 1873 in Lombard Street.