The concept has its origins in a problem which can occur in a domestic banking system in a scramble for liquidity as follows. Suppose one bank fails. This gives rise to fears on the part of other depositors about the soundness of their own banks, and they go to get cash accordingly (in the nineteenth century in the form of gold or in Britain as Bank of England notes). But banks do not hold all funds deposited with them as cash, so all banks together cannot cope with a mass withdrawal. One bank could, by getting cash from other banks; but the only and ultimate source of cash for the whole system in a system with a central bank is the central bank.
The problem and the solution were both described well by two eminent nineteenth-century writers on monetary economics. First, the problem: 'If any bank fails, a general run upon the neighbouring banks is apt to take place, which if not checked in the beginning by a pouring into the circulation of a very large quantity of gold, leads to very extensive mischief' (Thornton, 1802, p. 97); and then the solution: 'What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could really be convinced that they would have money ... most likely they would cease to run in such a mad way for money' (Bagehot, 1873, p. 106).
Acting in the way Bagehot prescribed could, it was asserted, prevent the problems associated with a banking system collapse. These problems are many, but most basic is the unanticipated collapse in the stock of money which it would produce. Such collapses cause severe recession, of which the Great Depression in the United States is the archetype. These can be prevented by taking the following action.
The central bank that experiences such a shock should lend freely on collateral. It should not restrict lending to the classes of security (usually quite narrow) that it would accept for discount during normal times. Advances should be made without limit, on demand, but at a rate of interest above the pre-crisis rate. These loans should be made to the market - that is, to anyone who brings in acceptable security. In addition (and argued in particular by Bagehot) it should be made clear that the central bank will act in that way should there ever be a crisis: this reduces the likelihood of runs because knowledge that the central bank will supply liquidity makes it seem less urgent to scramble for it.
That is the theory. Does it work in practice? There can be no doubt that it does. One often cited item of evidence is that there has been no such banking crisis in Britain since 1866 - by 1875 the Bank had accepted Bagehot's advice. The Governor of the Bank from 1875 to 1877, H.H. Gibbs, described the 1866 crisis as 'the Bank's only real blunder in his experience'; but he did not criticize the then Governor, for 'the matter was not as well understood then as it is now' (Gibbs, 1877, p. 15).
The other example is the Great Depression in the US. There were several contributing factors, but the major one was undoubtedly the failure of the recently established Federal Reserve System to act adequately as lender of last resort in the waves of bank failures from 1930 to 1933. The Federal Reserve's failure led in 1934 to the establishment of deposit insurance - a perhaps unhappy precedent to which we return.
Less well-known examples are France and Italy. In both countries LOLR action prevented bank runs, and its absence allowed them.
That, then, is the essence of domestic LOLR action. It is rapid, involves the abundant supply of domestic money on the basis of provision of collateral, and does not involve bailing out individual institutions.9
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