Contemporary Finance

18Regulation for Financial Stability

18.1 The Lender of Last Resort Function

18.1.1 Bagehot’s Rule

The Bank of England’s (Bank) role in addressing financial crises, like its role in monetary policy, emerged in response to a series of crises during the late 18th and 19th centuries. Bagehot’s Rule, published in 1873, articulated a Responsibility Doctrine, an idealized description of the Bank’s duties in a crisis. The rule distinguished appropriate Bank responses to a surge in presentation of banknotes for gold. In an internal drain, a likely transitory desire for liquidity, the Bank should lend freely and without delay. In an external drain, in which gold flows out to foreign countries, it is more likely due to interest rates lower than is compatible with stable prices. The Bank should then increase rates, reducing reserves. If there is an internal and external drain, likely associated with bank failures and panic, it should lend freely but at a penalty rate.

The responsibility fell to the Bank because its size and central role in money markets gave it “the power of a large holder of money, and no more.”¹ Bagehot’s Rule provided lending guidelines for the lender of last resort (LOLR) function in financial crises that still inform advanced-economy central banks. LOLR financing is to be a backstop to keep it from displacing the private funding on which borrowers should primarily depend and to insure a reversion to normal once the crisis is over. The central bank is to lend on ...