Reconsidering Central Bank Lending of Last Resort

Central banks serve many key roles in financial markets and economies. One of their most important tasks consists of lending of last resort. When standard sources of funding dry up, banks and increasingly other financial institutions expect central banks to replace conventional lenders. Changed realities in financial markets, however, challenge central banks to reconsider the terms traditionally applied to their emergency lending facilities. The Bagehot dictum, providing the elementary criteria for last resort lending, must be reassessed in light of today’s large, interconnected financial markets in which banks pose enormous threats to financial stability and transposition of monetary policy has become more complicated for central banks. This article analyses these issues from the perspective of lending of last resort by the US Federal Reserve System (‘Fed’), the central banks of the Eurozone (‘Eurosystem’) and the Bank of England. It argues in favour of robust and reliable lending criteria and consequently the elimination of the principle of constructive ambiguity and a flexible application of all other traditional lending requirements. Central banks do not operate in a legal vacuum, but the legal provisions on which such lending relies have been given little attention. The article breaks with this tradition, focusing on the Eurosystem whose legal framework leaves important issues unaddressed. It calls for an explicit mandate of financial stability for the Eurosystem that prescribes the circumstances under which financial stability takes priority over the price stability objective.