The core principles for the economy’s lender of last resort were passed down to us by Walter Bagehot, an English journalist, after London’s 1866 banking crisis. They are that central banks should make clear that they stand ready to lend early and freely (i.e. without limit), to sound firms, against good collateral and at rates higher than those prevailing in normal market conditions. But, a century and a half later, we cannot just leave it at that because our circumstances differ hugely from his.
In Bagehot’s day, the Bank of England, although largely an organ of the state, was privately owned. Britain had not embraced full suffrage. The country was on the gold standard, so a run on the banks could be a run into gold, potentially creating external strains. There was no statutory system of prudential regulation and supervision, no deposit insurance and no special resolution regime for banks – just a bankruptcy regime for firms and natural persons.
Today, the modern LOLR operates in a world of fiat money, with monetary policy delegated by democratic legislatures to independent central banks and, in the context of rich (but still incomplete) regimes for banking regulation, supervision and resolution.
Last year, I was commissioned by the Swiss government to review lessons from the collapse of Credit Suisse for LOLR regimes. Published in April 2024 alongside the Swiss government’s plans, my report aims to update LOLR doctrines for today’s world. Here I focus on two big lessons, which are also relevant to the collapse of Silicon Valley Bank in the US.
The first lesson is that lending of last resort to specific firms should not be thought of as being limited to forestalling a run or bridging to a fundamental solution of some kind, such as a takeover. It needs to include lending to a firm whose solvency has been restored via resolution but initially continues to struggle to fund itself in markets.
In a new twist, the Credit Suisse affair highlights the possibility – whether or not wholly true in its case – that a comfortably solvent firm might implode from an avalanche of reputational problems, in which case the LOLR needs to be ready to fund an open-bank wind down: a kind of conservatorship, possibly involving shedding specific businesses and subsidiaries by flotation or trade sales. That kind of wind down was last considered by international officials nearly 25 years ago, and now obviously needs to be revisited in the light of the post-2008 financial crisis resolution regimes.
The second lesson is that central banks need to know comfortably in advance – as should bank supervisors and resolution authorities – whether each bank has enough acceptable collateral to absorb a run. Both the Credit Suisse collapse and the US regional bank failures lend force to the proposal advanced for some years by Mervyn King, former Bank of England governor, and me that each banking entity should pre-position with their central bank enough assets to cover 100% of its short-run liabilities (out to some horizon).
Operationalising central banks’ high-level collateral policies into day-to-day routines, pre-positioning ensures all parties are ready operationally whenever the music stops. The Credit Suisse affair reveals another great benefit, which is discovering in good time which banks do not have nearly enough collateral to absorb a run. Spotted during financial peacetime, the authorities can require business and funding models to adjust. The Swiss authorities’ preparations were, in my view, woefully inadequate in this respect.
In a transparent regime, each central bank should make clear it will lend against a wide range of collateral, subject to the vital test that it understands and is able to manage such assets, including being able to realise them in the event of default. Pre-positioning is a mechanism for revealing when a bank cannot meet those tests, leaving unsecured lending by the fiscal authority as the only option. Home country taxpayers might face that ghastly situation when many of a bank’s assets are in foreign jurisdictions without the rule of law or are hard to realise or collect for other reasons (e.g. loans to tycoons secured by highly mobile assets such as yachts). The authorities have barely begun to confront this, and yet something like it has now punched them in the face.
Credit Suisse is the first globally systemically important financial institution to fail since the post-2008 financial crisis reforms. This was a seismic blow to international banking that, oddly, has not commanded attention outside Switzerland itself.
As my report concluded, the episode ‘should be causing sleepless nights among central bankers, supervisors and resolution agencies because CS was surely systemic for many of them too. Their political overseers should be wondering, therefore, whether their own plans for local firms are as good as made out. Perhaps they are, but many had thought Switzerland to be in the vanguard.’
Paul Tucker is former Central Banker and Research Fellow at Harvard Kennedy School’s Mossavar-Rahmani Centre for Business and Government. He is author of ‘Global Discord: Values and Power in a Fractured World Order’ and ‘Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State’.
Read the full report for the Swiss government here.
