Daniel Davies is a managing director at Frontline Analysts, and the author of ‘Lying for Money: How Legendary Frauds Reveal the Workings of Our World ‘.
Anyone who follows central banks knows that there are some subjects they love talking about endlessly (inflation forecasts), some they’re less happy being open about (quantitative easing) and some where they’re hardly prepared to talk at all.
The key function of “lender of last resort” is very much in the third category. In the language of memes:
Which makes it surprising that the Bank for International Settlements published a short four-page document last Wednesday which seems to set out an entire policy framework for the extension of that role to emergencies in all kinds of financial markets, potentially going well beyond the banking system .
Only true central bank trainspotters will have seen it, given the lack of a press release and the unassuming title of “Market dysfunction and central bank tools: Insights from a Markets Committee Working Group“, But it’s actually quite radical.
Here’s why it matters
Being cagey about the circumstances in which central bank support might be offered is an old tradition. If you ever want to learn about last-resort lending to the banking system, arguably your best reference is still “Lombard Street”, By Walter Bagehot. Despite being written in 1873 by the then editor of The Economistover time central bankers have tacitly and grudgingly admitted that the book has things about right.
Ever since the Great Financial Crisis, economists like Perry Mehrling have been arguing that we need a “New Lombard Street”, because the Federal Reserve, Bank of England, European Central Bank and the rest have steadily taken on a role as “dealer of last resort” when securities markets threaten to blow up.
However, hardly anyone has been optimistic for the prospects of getting any clear policy statement. And by and large the central bankers themselves have taken the Fight Club approach to their most politically sensitive and economically risky activity.
But now we have the equivalent of a TED Talk on the subject. The “Markets Committee” of the BIS is an obscure cousin of the Basel Committee on Banking Supervision, formerly known as the Committee on Gold And Foreign Exchange.
They’re central bank operations and markets people, most famous for rewriting the FX Code. And they’ve made a straightforward statement, in reasonably clearly written English, of what they call the “Backstop Principle”.
. . . In situations where it appears likely that market dysfunction will have a material adverse impact on the real economy, central banks should consider using their ability to expand their balance sheets and provide liquidity in order to mitigate this impact.
This looks like it could form the basis for a quite activist policy; it would suggest that central banks did the right thing in March 2020, when they flooded the market with liquidity to prevent bond markets locking up at the start of the COVID pandemic.
The Markets Committee is still a little bit worried about moral hazard in the long term. But the caveat they make looks more like a definition of what constitutes a “backstop” than anything which might justify ever letting an economically-significant market freeze up.
. . . Central banks should aim under normal market conditions not to (i) interfere with price discovery or market determination of the allocation of resources; or (ii) substitute for the primary obligation of market participants to manage their own risks. ..
The document identifies a number of “open issues” which also touch on previously neuralgic policy issues. It suggests that in many cases, outright asset purchases can be a more powerful tool of intervention than just providing liquidity through the banking system, as QE purchases can directly attack mispricings and balance sheet overhangs (at the cost of probably creating worse moral hazard and exposing the central bank balance sheet to more risk, but swings and roundabouts etc).
It also holds out the possibility that the lender of last resort function shouldn’t necessarily be restricted to banks – any institution that’s subject to “appropriate regulation and supervision” might reasonably be given emergency liquidity in a crisis.
So the interesting question arises – what is the status of this document? If it were to be a general statement of global central bank policy, it’s one of the most important such statements since the days of Bagehot. Although the authors recognize that different countries and situations will interpret it differently, the backstop principle itself gives a lot more clarity about the circumstances in which central banks will and won’t ride to the rescue.
It isn’t such a statement, of course. It’s an ad hoc publication by a working group of a committee, with only two members of that working group named (Andy Hauser of the Bank of England, and Lorie Logan, now off to lead the Dallas Fed but at the New York Fed’s markets desk when it was written). The backstop principle isn’t binding on anyone, either for action or inaction.
But it’s not just a thrown-off thinkpiece either. It’s something that a committee of the BIS – a famously consensus-driven club of central banks – has decided is worth putting in the public domain.
In terms of a new Lombard Street, this is likely to be as much as we’re going to get, and more than we were expecting.