On Friday, at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium, Brian F. Madigan, the Director of the Federal Reserve’s Division of Monetary Affairs, gave a speech entitled “Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis.” In his speech, Mr. Madigan discussed the challenges faced by the Federal Reserve during the current financial crisis and offered recommendations for policies to consider during a future crisis.
Mr. Madigan structured his observations and recommendations around the analysis provided by Walter Bagehot in his 1897 book, Lombard Street: A description of the Money Market. According to Bagehot, “[T]o avert panic, central banks should lend early and freely (i.e. without limit), to solvent firms, against good collateral, and at ‘high rates’” (quoting Paul Tucker’s summary of Bagehot’s dictum). Throughout his speech, Mr. Madigan used this framework to discuss the Federal Reserve’s recent lending strategies and programs in the context of (i) commercial banks and other depository institutions, (ii) primary dealers and investment banks, (iii) money market mutual funds and commercial paper issuers and (iv) investors in asset-backed securities. From these observations regarding the Federal Reserve’s response to the current financial crisis, Mr. Madigan offered five “lessons” that may be used in analyzing a future financial crisis:
- “[I]n extraordinary circumstances, central banks may well need to take measures to prevent systemic collapse that are unprecedented in their details; but such measures may still be quite congruent with established central banking principles;”
- “Going forward, central banks and other policymakers need to avoid measures that could further exacerbate the stigma of using central bank lending facilities…And they should consider whether some now-existing arrangements…need to be adapted and made permanent, or new facilities established;”
- “Any financial system that includes systemically important nonbank financial firms with significant amounts of illiquid assets and short-term liabilities…requires a mechanism for lending to such firms at least in crisis situations;”
- “[A] means of lending in contingency situations even to nonbank firms that may not be systemically critical in themselves would seem necessary to promote a suitable degree of financial stability;” and
- “[A] workable regulatory system must incorporate a mechanism to extend central bank credit to entities that are not normally eligible to borrow from the central bank; no reasonable system of regulation can draw a bright line that cannot be crossed between banks and nonbanks.”
In closing, Mr. Madigan stated that “as Bagehot recommended, we should look to the restrictions of lending only to solvent firms, only against good collateral, and only at high rates to limit distortionary effects on markets and to protect the fisc while allowing central bank credit to prevent financial panics from having excessively adverse effects on economic activity and employment.” However, he also noted that “Bagehot's precepts need to be interpreted and applied in light of practical considerations, and that application is not necessarily straightforward,” although he does regard Bagehot’s dictum as “a useful framework for the formulation of central banks’ policy actions in a crisis.”