Thus when Walter Bagehot settled down to write his Lombard Street, he had at his back not only the analytical apparatus of British classical political economy but also half a century’s worth of policymakers’ experience at dealing with financial crises, and policymakers’ memoirs in which they reflected upon their experience. He thus had several rich veins of material to draw upon as he attempted to systematize what was known about how central banking worked in a financial crisis. The mid-nineteenth century practice of central banking he took it upon himself to rationalize and explaican be summed up simply: when, in a financial crisis, private savers want desperately to hold more safe, liquid savings vehicles, give them what they want.
And Bagehot explained how a central bank should go about doing this with four rules:
His first rule is that the central bank exists to keep the fall in the supply of safe, liquid savings vehicles in a financial crisis as small as possible, and to do so by lending freely to all--or at least to all who have collateral to indicate that they would be solvent if times were normal and if the financial crisis had passed:
They must lend to merchants, to minor bankers, to ‘this man and that man’, whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.... On the surface there seems a great inconsistency... like saying--first, that the reserve should be kept, and then that it should not be kept. But there is no puzzle..... The ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for... meeting a demand for cash caused by an alarm within the country..... [W]e keep that treasure for the very reason that in particular cases it should be lent...
Bagehot’s second rule is that it is very dangerous to place an ex ante limit on how much the monetary authority will commit to operation as a lender of last resort: the central bank needs to stand ready to expand the supply of safe, liquid assets by as much as turns out to be necessary, which may be more (or less) than anybody thinks possible (or necessary):
[A]n opinion that most people, or very many people, will not pay their creditors; and this too can only be met by enabling all those persons to pay what they owe, which takes a great deal of money.... Just so before 1844, an issue of notes, as in 1825, to quell a panic entirely internal did not diminish the bullion reserve. The notes went out, but they did not return. They were issued as loans to the public, but the public... never presented them for payment..... [W]e must keep a great store of ready money always available, and advance out of it very freely in periods of panic, and in times of incipient alarm...
Bagehot’s third rule is that the central bank must not play favorites:
[A]dvances should be made on all good banking securities, and as largely as the public ask for them.... The object is to stay alarm.... But the way to cause alarm is to refuse some one who has good security to offer.... If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed...
The purpose is to destroy risk. And the risk that a particular firm’s assets will not receive symmetrical treatment with the assets of other, more favored firms is not an extra source of risk that needs to be introduced.
Bagehot is often glossed as if he had declared that a central bank in a financial crisis should lend to illiquid but not insolvent institutions. But it is difficult to see how any institution whose solvency is common knowledge could possibly be illiquid. Indeed, it is only because the central bank’s solvency is common knowledge that it can create the safe, liquid “outside money” needed to reflate the financial system in a financial crisis. Bagehot did not say “illiquid but not insolvent”. He said something more clever: that the central bank should be seen to be “freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible”, then “the alarm of the solvent merchants and bankers will be stayed”.
And Bagehot’s fourth rule is that central bank lending in a financial crisis should be undertaken at a “penalty rate”: nobody—no organization, no manager, no trader, and no investor—should end the crisis in any sense happy that they were forced to rely on the government. This would appear to mean, particularly, that equity should be extinguished before the central bank begins providing support at interest rates that are at all concessionary. To the extent that equity rights are preserved as less than a proper penalty rate is charged, the criticism that the central bank has unnecessarily provided incentives for moral hazard is unanswerable.