Bagehot’s Dictum and Discretionary Benefits in the Absence of Rules-Based Lender of Last Resort Policy

Abstract

Given that the market order is a function of the underlying “rules of the game” set forth by centralized, policy-making bodies, a common rationale for binding these bodies to a “constitution” or set of general rules is so that they don’t have the discretion to benefit certain actors at the expense of others. This paper argues that in the wake of the 2008 Global Financial Crisis, the Federal Reserve’s lender of last resort (LOLR) policy did discretionarily benefit certain financial institutions at the expense of others, rescuing several insolvent primary dealers that it otherwise would not have had it followed “Bagehot’s dictum,” a general procedure for LOLR policy that has served as an implicit monetary constitution for the Fed under Chairman Ben Bernanke. Specifically, “Bagehot’s Dictum,” introduced by Walter Bagehot in 1873, argues that a central bank ought to lend ordinarily marketable collateral at a penalty rate, all while lending to firms that are illiquid but not insolvent. Despite Bernanke’s defense that the Fed had adhered to this dictum in 2008, unorthodox LOLR practices such as direct bailouts, “quantitative easing” (QE), and newly established credit facilities each served to directly assist larger banks with more questionable collateral and solvency status. It is argued that often times, this constitutional deviation came at the expense of smaller yet solvent banks, who saw decreased access to liquidity both as the result of several credit facilities as well as following the establishment of an “interest on excess reserves” rate (IOER) that was necessary to offset the inflationary effects of QE. In order to avoid making such a tradeoff in the first place, it is argued that the Fed publicly returns to adhering to a constitutional standard such as “Bagehot’s dictum” in its LOLR policy.

Keywords

LOLR policy, Bagehot’s Dictum, TARP, PDCF, TSLF, Quantitative Easing, IOER

Introduction

Why do we often bind centralized institutions to a “constitution,” or a set of general procedures and rules, rather than granting them the discretion to enact different measures on a case-by-case basis? This has been a central question within the field of classical liberal thought, pointing towards the notion of the rule of law. Friedrich Hayek argues that, for a legal system to be consistent with the rule of law, it “is to limit coercion by the power of the state to instances where it is explicitly required by general abstract rules which have been announced beforehand and which applied equally to all people, and refer to circumstances known to them” (Hayek 1955, p. 34). Hayek’s deliberation of the rule of law suggests that we often establish general, abstract rules in the name of justice, which is often defined as “the opposite of arbitrariness” (Miller 2023). In other words, for a system of law to be just, it must be impartial and therefore general in its scope, instead of arbitrarily benefitting specific parties based on the policymaker’s discretion. With this emphasis on justice in mind, the apparent need for binding institutions to a “constitution” of general rules can be extended into any avenue of policymaking, including economic policy.

Operating under the assumption that the economy’s underlying rules and institutions greatly determine the working processes and outcomes of its economic decisions, it becomes evident that such rules and institutions must be kept general and abstract in scope to preserve this notion of justice in the market order. If we were to retain this emphasis on the need for impartial, general rules from economic policymakers, all while engaging in the traditional discussion of how to better general economic outcomes, we would arrive at the central normative question of the ordoliberal research paradigm: how can we improve the “rules of the game” in a manner that ensures that private actors, pursuing their self-interest, also benefit the common interest?^[1] Applying this question to the institution of central banking in the context of lender-of-last-resort (LOLR) policy, central banks facing financial turbulence have frequently adhered to “Bagehot’s Dictum”—a set of general rules prescribed by the English financial journalist Walter Bagehot (1826-1877) that the central bank ought to adopt in its financial assistance to illiquid banking institutions. “Bagehot’s Dictum” has faced notable approval, both within the economics profession and from former Federal Reserve Chair Ben Bernanke himself. The purpose of this paper, however, is to explore how Bernanke’s Fed violated Bagehot’s Dictum in its response to the Global Financial Crisis of 2008, and how this violation of a general, abstract procedure for lender-of-last resort policy resulted in discretionarily benefitting certain financial institutions over others. Such “unjust” manifestation of lender-of-last resort policy, directly intervening within the market order and not only favoring certain private institutions but at times doing so at the expense of others, illustrates the need for a lender-of-last resort policy grounded in a general set of rules, much like the one offered by Bagehot’s Dictum.

Bagehot’s Dictum and the Reason of Rules

In his 1873 work Lombard Street: A Description of the Money Market, the English financial journalist Walter Bagehot thought of conceiving the first normative standard for LOLR policy for a central bank to adopt. This arose in response to the perceived inaction of the Bank of England in the wake of the Financial Panic of 1866. While Thornton (1802) alluded to many of the lending principles that Bagehot would prescribe, the latter offered a more systemic body of procedures for the central bank to adhere to. Paul Tucker (2009) summarizes this standard as, “to avert panic, central banks should lend early and freely (i.e. without limit), to solvent firms, against good collateral, and at ‘high rates’.” Combining this summary with similar deconstructions of the dictum offered by Allan Meltzer (1986, p.83) and Boettke et al. (2021, p. 100), we arrive at four distinct normative principles for Bagehot’s LOLR policy:

1. The central bank must lend to firms that are illiquid but not insolvent.
2. The central bank must lend on collateral that is ordinarily marketable.
3. The central bank must lend freely at a rate above the market interest rate.
4. The central bank must publicly embrace these above principles before it’s called upon to apply them, i.e. before a financial crisis.

In Bagehot’s words, “the majority to be protected” by the central bank and its lending “are the ‘sound people’, the people who have good security to offer,” a category he otherwise defines as “solvent merchants and bankers” (Bagehot 1873, VII.58)^[2]. Bagehot’s concern over loan recipient solvency reflects the journalist’s foretelling of potential moral hazard complications, an obviously prescient phenomenon that he uses to justify the next two principles. Principles #1 and #2 work concurrently in the sense that firms able to offer “marketable” or good collateral are those that are able to remain solvent despite potentially being illiquid^[3]. Nonetheless, he advocates for the need for central banks to lend amongst illiquid yet solvent institutions freely, arguing that “the way to cause alarm is to refuse someone who has good security to offer.” (VII.58). Meanwhile, loans should be made “at a very high rate of interest,” as it “will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it.” (VII.57). Finally, Bagehot insists that if the central bank does not publicly commit to these procedures early or before the crisis, “both our liability to crises and our terror at crises will always be greater than they would otherwise be” (VII.75). Thus, as Boettke et al. (2021, p.99) discuss, the overarching rationale for Bagehot’s distinct principles of central bank lending is so that “banks have an incentive not to engage in the kinds of behaviors that turn prosperous times into difficult times.” By simultaneously lending freely to solvent institutions while ensuring it is done at a penalty rate and on good collateral, Bagehot attempts to optimize both liquidity and market discipline within the financial sector.

Although expressed over a century and a half ago, (under a radically different central bank setting,)^[4] Bagehot’s lending principles have remained incredibly relevant to the present day. Section 13(3) of the Federal Reserve Act arising under the Dodd-Frank Wall Street and the 2010 Consumer Protection Act exemplify the notion that LOLR policies are conducted, “for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses.” Meanwhile, the principles have consistently defined the Bank of England’s LOLR policy throughout the 20^th century (Humphrey 1989), as well as the responses from the Fed under Chairman Alan Greenspan to the 1987 stock market crash and post-9/11 financial market turmoil (Humphrey 2010). Most notably, Greenspan’s successor Ben Bernanke has repeatedly claimed that the central bank’s response to the Global Financial Crisis of 2008 adhered to the 19^th century journalist’s principles^[5]. For example, in a 2012 lecture at George Washington University, Bernanke contended that, “in the financial panic, the central bank has to lend freely according to Bagehot’s rules to halt runs and to try to stabilize the financial system” (Bernanke 2012, p.10). These remarks served to be a line of defense from the former Fed Chair considering the unprecedented LOLR policy that the central bank had taken during the crisis. Nonetheless, Bernanke’s line of defense contradicts the explanations of other senior officials at the time. Former Vice Chair Donald Kohn similarly defends that, “although the Federal Reserve’s lending actions during the crisis were innovative and to some degree unprecedented, they were based on sound legal and economic foundations,” which purportedly conclude, “lending to solvent institutions against illiquid collateral,” (Kohn 2010). Given that a defining feature of marketable collateral is their liquidity, Kohn’s justification of lending on illiquid collateral conflicts with Bernanke’s explanation that the Fed had adhered to Bagehot’s rules, among them, the need to lend on marketable collateral.

Who are we to believe over the Fed’s lending practices in 2008, Chairman Bernanke or Vice Chairman Kohn? As will be seen, the correct answer is neither. The Fed did, in fact, lend on illiquid and therefore generally unmarketable collateral, but it also extended its lending to insolvent institutions in the process. Meanwhile, its establishment of alternative lending facilities in the crisis largely served to counteract the Bagehotian principle of lending at a penalty rate. Bagehot, as illustrated previously, already sheds light on some of the economic consequences of evading these principles. Based on the prior discussion on justice and the rule of law, however, another consequence of evading certain rules for LOLR policy is the enlarged likelihood that certain actors may benefit from the newfound discretion of policymakers far more than other private actors. Insofar as justice and impartiality in the law can be agreed upon as a public good, it is necessary to illustrate how certain financial firms and institutions arbitrarily benefitted more than others from LOLR policy in 2008. While alternative lending rules may be even more effective in preventing this discretionary favoritism going forward, this discussion serves as a starting point in illustrating how a mainstream lending theory such as Bagehot’s Dictum may prove more desirable in furthering a notion of justice and the rule of law than a lack of adherence to any lending rules in the first place.

TARP and Discretionary Bailouts

In October of 2008, Congress passed the Emergency Economic Stabilization Act, authorizing the Troubled Asset Relief Program (TARP) which, in the words of Bernanke (2008), was meant to “create liquidity and promote price discovery in the market” through the “purchases of illiquid assets from banks and other financial institutions.” Although under the direction of the Treasury Department, TARP’s creation and execution were majorly influenced both by Bernanke at the Board of Governors and Timothy Geithner, President of the New York Fed.^[6] On the one hand, the idea of purchasing toxic assets as a means of injecting liquidity, a venture labeled as a “$700 billion bailout for the financial system” by the press (Herszenhorn 2009), is decidedly anti-Bagehotian in nature. While not directly contradicting the journalist’s principles, it goes well beyond the scope of cautious LOLR policy that he had ascribed to the central bank. Calomiris and Khan (2015, p.62) argue that both TARP and the Capital Purchase Program (CPP) under its umbrella rejected Bagehot’s Dictum through their widespread purchases of common stock from target recipients; as successfully taken into consideration by the Roosevelt Administration in 1933 during the Great Depression,^[7] purchasing common stock is prefaced on the assumption that illiquidity among financial institutions is a symptom of a much more systemic risk of insolvency. Thus, the calculus behind TARP strongly implies that the Fed and the Treasury were fully equipped and willing to lend to institutions not only on the brink of insolvency but, as will be seen, institutions that were already insolvent.

The Fed most clearly violated Bagehot’s Dictum through its major bailouts of insolvent institutions such as Citigroup and AIG. In addition to $45 billion provided through TARP, the Fed alongside the Treasury and FDIC guaranteed up to $306 billion in loans for Citigroup in November of 2008 (Federal Reserve et al. 2008). This bailout came, however, as Citigroup announced the layoff of 52,000 employees, and even as analysts expected the bank to not be able to make money before 2010 (Stempel and Wilchins 2008). As Zwikel (2009) expresses, “The market has voted and considers Citi (in terms of its common stock) insolvent. For some reason, the government feels that with more taxpayer money and time the company’s solvency problem will resolve itself.” In the instance of AIG, it is largely understood that the New York Fed’s $85 billion emergency bailout in September of 2008 prevented a full-blown bankruptcy by a matter of days (Federal Reserve 2008a). Obviously, a bank must be insolvent to declare bankruptcy, but Sjostrom (2009) argues that “the necessity of the bailout was dubious,” as AIG had likely “overblown” the severity of its bankruptcy to the rest of the financial system in order to ensure a bailout. Juxtapose these bailouts to the failure of Lehman Brothers in the same month. Cline and Gagnon (2013) find that if solvency is defined as “having a positive net worth in a hypothetical liquidation at current market prices,” then Citigroup, AIG, Lehman, and many other institutions would have been considered insolvent^[8]. It is evidently arbitrary (and representative of a discretionary, anti-Bagehotian LOLR policy) that insolvent firms including Citigroup and AIG received massive sums of liquidity injections whereas other insolvent firms such as Lehman were allowed to fail. While Bernanke et al. (2019) argue that bailout policy adhered to a Bagehotian framework of whether the firm posed sufficient collateral, Ball (2018) finds that based on the many internal communications between the Fed and Treasury leading up to Lehman’s bankruptcy, “the discussions had nothing to do with the Fed’s legal authority or Lehman’s collateral. Instead, Lehman’s fate was determined by officials’ views of the political and economic consequences of a Lehman rescue or a Lehman bankruptcy.” Given that its bankruptcy is widely considered to be a starting point of the Global Financial Crisis, however, there may not be much plausibility behind this justification for the utter discretion behind bailouts for certain insolvent firms but not others. Clearly, by evading the insolvency principle, the Fed and the Treasury jointly and arbitrarily favored certain insolvent institutions over others. 

There is overwhelming evidence to suggest that this was a defining theme for both TARP and CPP, with more politically connected and active firms being significantly more likely to be bailed out by these programs. Blau et al. (2013) find that “for every dollar spent on lobbying during the five years prior to the TARP bailout, firms received between $485.77 and $585.65 in TARP support.” Vukovic (2021) finds a causal relationship between the level of lobbying activity and campaign expenditure in 2008-2009 and the bailout package size among TARP aid recipients. Specifically, Duchin and Sosyura (2012) find that among firms who received liquidity through CPP, there is “a strong positive relation between a firm’s political connections and its access to federal investment funds.” In a similar vein, Mian et al. (2010) find that “special interests in the form of higher campaign contributions from the financial industry increase the likelihood of supporting the Emergency Economic Stabilization Act” which authorized TARP and its CPP. By extending beyond self-imposed constraints laid forth by Bagehot and accumulating the discretion of direct liquidity injections through TARP, both the Fed and the Treasury inefficiently allocated taxpayer money by rewarding financial institutions based on factors other than solvency. The establishment of the program not only reflected an unprecedented extension of LOLR policymaking, but was at least partially enabled by the political lobbying of TARP’s would-be recipients in the process, who anticipated the arbitrary benefits of a discretionary allocation of liquidity.

Whereas a Bagehotian standard would see the Fed indiscriminately lend to illiquid institutions, the establishment of TARP and the authorization of direct bailouts instead saw the central bank discriminate amongst both illiquid and insolvent institutions. The simultaneous bailout of Citigroup and AIG alongside the allowed failure of Lehman is evidently arbitrary. Meanwhile, the tendency to allocate the $700 billion authorized for TARP towards select firms incentivizes rent-seeking rather than justly and freely lending to all illiquid institutions as Bagehot would recommend. Both, however, are prefaced on the decidedly anti-Bagehotian idea of purchasing common stock and other illiquid assets rather than lending on marketable collateral.

Credit Facilities and Primary Dealer Favoritism

Accompanying the bailouts of certain “too-big-to-fail” institutions through TARP and beyond was the Fed’s unprecedented expansion of lending services through a variety of newly established credit facilities, including the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF). The PDCF, deemed the Fed’s “most radical change in monetary policy since the Great Depression,” (Acharya and Öncü 2010, p.337) was established on March 16, 2008 as an alternative to the discount window albeit with some notable deviations from the lending norm^[9]. While both facilities lent at an overnight rate 25 basis points higher than the federal funds rate (a “penalty rate” as Bagehot would advise), the PDCF saw the Fed expand the range of its lending to “non-bank primary dealers” (Eisenbeis 2010) including Goldman Sachs, J.P. Morgan Securities, and Morgan Stanley among other institutions largely outside the Fed’s supervision (Sheridan 2011, p.29). Most notably, months later following the collapse of Lehman, the PDCF allowed primary dealers to secure loans on riskier, unmarketable collateral, with the intention of even further expanding liquidity access to primary dealers (Selgin 2012, p.311). Recall, however, how the principles within Bagehot’s Dictum are interconnected. By allowing overnight loans to be secured by unmarketable collateral, potentially insolvent institutions are granted an additional lifeline that they otherwise would not be given. Boettke et al. (2021, p.99) write, “The good collateral requirement makes it very difficult for insolvent institutions to swim when by rights they should sink. After all, if their collateral were good, they would not be insolvent.” This was precisely the case with the PDCF, in which of the nearly $9 trillion in lending offered by the facility, Citigroup, Goldman Sachs, Merrill Lynch, and Morgan Stanley borrowed around $2 trillion each (Sheridan 2011, p.13-14). While none of these institutions may have necessarily been insolvent altogether, the lack of restrictions surrounding collateral quality may have certainly diverted liquidity access from smaller, illiquid institutions to the aforementioned primary dealers.

Established less than a week before the PDCF following the collapse of Bear Sterns, the Term Securities Lending Facility (TSLF) was designed to work in tandem with the previously mentioned facility. The TSLF saw the Fed loan liquid, marketable Treasury securities to primary dealers in exchange for riskier, unmarketable assets for about a month at a time (Weinberg 2015). These Treasury securities, in turn, served as collateral for primary dealers to secure loans through the PDCF, at least until September 2008 when these dealers could lend on far riskier assets (Burns and White 2019, p.372). By greatly expanding primary dealers’ firsthand access to federal funds, George Selgin (2012, p.310) writes that “the Fed felt obliged to rescue several primary dealers, and to do so at the expense of solvent banks.” In other words, the opportunity cost of the incredibly cheapened ability for primary dealers to access liquidity was the greater inability for secondary parties to draw upon funds in the monetary base. Writing about the TSLF, Robert Eisenbeis (2010) reflects, “That program provided effectively a reallocation of banking reserves to the primary dealers that would have otherwise been available to smaller banks or holders of Fed funds to support lending and asset acquisition.” This tradeoff between lending to unstable, primary dealers at the expense of solvent secondary parties was greatly enabled by two factors. One was the Fed’s decision to hold the monetary base relatively constant, with its holdings of Treasuries decreasing from $790.6 billion in July 2007 to September 2008. As a result, the monetary base grew by a mere 2.24 percent between August 2007 and August 2008 (Burns and White 2019, p.372). With a constant monetary base, one institution or group’s access to reserves inherently comes at the expense of another’s. The second factor is the “freeze” in the interbank market, as primary dealers, exercising caution under the heightened risk of default, raised their liquidity demand by 30%, thereby “hoarding” liquidity without distributing it to secondary parties (Acharya and Merrouche 2013). With these factors in mind, facilities such as the PDCF and TCLF may have served to discretionarily and directly allocate capital more than they did freely and generally inject liquidity into the money market.

This is a common theme among the vast array of credit facilities created by the Fed during the financial crisis. The Commercial Paper Funding Facility (CPFF) and the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), for example, both directly purchased commercial paper either from “large financial institutions” or conduits of said institutions (Kacperczyk and Schnabl 2009)^[10]. Other facilities such as the Money Market Investor Funding Facility (MMIFF) offered liquidity to primary dealers in order to purchase commercial paper from money market mutual funds (Federal Reserve 2008b). Credit facilities aimed at lending to specific institutions in order to bolster the values of specific assets serve to be the manifestation of a discretionary LOLR policy, one that “is firmly on the side of resource allocation rather than market stabilization” ^[11] (Boettke et al. 2021, p.104). As George Selgin (2012, p.311) notes, the flagrant disparities in outcomes of newly established credit facilities touch upon the larger problem of a primary dealer-based system of lending: “the Fed’s decision to support primary dealers was motivated, not so much by its desire to preserve them as direct agents for monetary policy, but by its fear that their failures could threaten the tri-party repo system by exposing one of the clearing banks to large losses.” Indeed, the primary dealer system may have compelled the Fed to engage in a discretionary, anti-Bagehotian lending regime that it otherwise would not have. Furthermore, the Term Auction Facility (TAF), while lending at a subsidized rate below that of the discount window, auctioned off collateralized loans to institutions outside of the discount window (ibid 2012, p.323-324). Insofar as facility lending can adhere to a penalty rate while lending indiscriminately to solvent institutions, the central bank may have demonstrated its capacity to coexist with Bagehot’s Dictum through a program such as TAF.

In total, however, a vast amount of newly established facility-sponsored lending during the Global Financial Crisis flagrantly violated his rules, whether by rejecting the collateral principle or by lending to large albeit questionably solvent institutions. Consequently, due in part to a constant monetary base and the phenomena of “liquidity hoarding,” credit was allocated within the money market rather than being injected with the necessary liquidity. Primary dealers were rewarded by this system, while smaller banks in secondary markets suffered. Nonetheless, in the discussion of facility-lending tradeoffs, another dimension is added when considering lobbying and its role in emergency lending. Benjamin Blau (2017) finds that, “after controlling for banks’ balance sheet structures, multivariate tests show that banks that had lobbied during the 5 years before the financial crisis were about 36% more likely to receive emergency loans than banks that had not lobbied.” Even if the Fed had attempted to adhere to Bagehot’s Dictum, lobbying from banks may have played a role in liquidity distribution. Their decision, however, to go beyond lending freely to illiquid institutions and to instead lend rather favorably to larger, potentially insolvent institutions would likely only exacerbate the effects of such connections.

Quantitative Easing and Interest on Reserves

Similar to the purpose of several credit facilities implemented to bolster the values of key assets, quantitative easing (QE) was initiated on November 25, 2008, as “a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)… and mortgage-backed securities (MBS),” with $100 billion in GSE direct obligations and $500 billion in MBS’s respectively being purchased by the Fed (Federal Reserve 2008c). Since this first round of QE (QE1) was successful in bolstering the values of MBS’s, primarily larger, over-leveraged institutions benefited the most: in 2009, 62.7% of MBS’s were held by “five major commercial banks,” consisting of Bank of America, Wells Fargo, Citigroup, J.P. Morgan, and Goldman Sachs (Trefis 2019). Even outside the financial sector, then-President of the Federal Reserve Bank of Richmond Jeffrey Lacker and John Weinberg (2015) write that “when the central bank buys private assets, it can tilt the playing field toward some borrowers at the expense of others, affecting the allocation of credit.” Specifically, the Fed’s large-scale purchase of MBS’s tended to “favor home-mortgage borrowers” but “increase(d) the interest rates faced by other borrowers,” such as those holding Treasuries (ibid 2015). Beyond these discretionary, allocative effects, the process of inflating institutions’ distressed asset values stands in stark contrast to the Bagehotian idea of freely supplying liquidity while ensuring that recipients are solvent enough to provide good collateral^[12]. Former Fed Chair Paul Volcker remarked that QE1 had taken the Fed, “to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices,” which “seems to test the time-honored central bank mantra in time of crisis—‘lend freely at high rates on good collateral’—to the point of no return.” (Volcker 2008). Despite this, by the third round of QE (QE3) in September 2012, the Fed had committed to indefinitely purchasing $40 billion worth of MBS’s per month, yet that figure was quickly revised to $85 billion per month (Federal Reserve 2012).

To adhere to Bagehot’s Dictum, the Fed could have constrained QE to the purchase of solely Treasury securities as in QE2, when the Fed announced a $600 billion Treasury security purchase in November 2010. Lacker and Weinberg (2015) express that, “When the Fed buys Treasury securities, any interest-rate effects will flow evenly to all private borrowers, since all credit markets are ultimately linked to the risk-free yields on Treasurys.” Yields on Treasury securities, in other words, serve as a benchmark for all other interest rates within the market for money and credit, as well as a safe asset that illiquid yet solvent institutions may utilize as collateral. Yet by inflating specific assets’ values and yields, the central bank unevenly allocates credit within both the market for the asset and its derivatives market as well ^[13].

Beyond the distinction between different securities targeted by QE, the Fed’s large-scale asset purchases (LSAP’s) was a contributing factor to the Fed’s installment of an “interest on excess reserves rate” (IOER) in October 2008. IOER was intended to “give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target,” (Board of Governors). However, Bernanke (2017) reflects in a later memoir that, “in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy.” Clearly, despite previous attempts at injecting liquidity through QE1, the bailout of AIG, and the establishment of the PDCF and the TSLF, the Fed’s incentivization for banks to sit on their reserves actively contradicted its otherwise expansionary monetary policy. As George Selgin (2018) proposes, “Although they were keen on providing emergency support to particular firms and markets, Fed officials recognized no general liquidity shortage calling for further monetary accommodation. The challenge, as they saw it, was that of extending credit to particular recipients without letting that credit result in any general increase in lending and spending.” The IOER presents a clear tradeoff. Recall that the aforementioned initiatives prior to October 2008, such as credit facilities and QE1 had the tendency to reward larger institutions. As these larger institutions’ balance sheets balloon from the injection in liquidity, they are further rewarded for holding onto their reserves, at the expense of allowing greater liquidity to circulate among the federal funds market. This “hording” of reserves would also prevent the subsequently lower federal funds rate to allow greater liquidity access for the wider economy.

Indeed, cash assets held by large domestic commercial banks increased at a far faster rate than those of small domestic commercial banks (Craig and Middleton 2017)^[14]. Selgin (2018) writes that, “As of early 2015, the top 25 U.S. banks, by asset size, held more than half of all outstanding bank reserves, with the top three alone holding 21 percent of the total, while foreign bank branches accounted for most of the rest. The cash assets of small U.S. banks, in contrast, rose only modestly.” In total, the introduction of an IOER demonstrates the inability of the Fed to adhere to the Bagehotian prescription of freely lending liquidity. Moreover, it may represent the central bank’s inability to even embrace its role as a lender of last resort in the first place. After all, the fourth principle of Bagehot’s Dictum advocates that the central bank publicly commit to the other three principles before the financial crisis begins. Given that the IOER reflects the Fed’s concern with too much liquidity in the interbank market, the Fed failed to publicly commit to freely providing liquidity during the crisis.

Conclusion

There is little doubt that conducting LOLR policy in response to the Global Financial Crisis, no less any financial crisis, is an incredibly difficult and unenviable task. Indeed, the case may be that Bernanke and the Board of Governors, alongside the New York Fed and the Treasury Department, went to great lengths to prevent the financial crisis from further worsening. Instead, the purpose of this discussion was twofold: one, to demonstrate how many of the unprecedented and unorthodox decisions made by the Fed in 2008 served to violate Bagehot’s Dictum and, two, to establish how these specific measures arbitrarily favored certain parties, institutions, or markets over others. Insofar as it can be agreed that justice is “the opposite of arbitrariness,” and justice is a sought-after public good, it is necessary to hold LOLR policy accountable to the “rule of law,” or the idea of establishing justice through adherence to general rules rather than discretionary interventions intended for specific outcomes. Bagehot’s Dictum is one such codification of general rules in the context of LOLR policy and has historically proven to be particularly popular in the realm of central banking. Therefore, comparing and contrasting the Fed’s lending practices in 2008 to the dictum proves to be an important means of uncovering the discretion behind many of the central bank’s responses to the crisis. That does not preclude, however, the possibility of there being a more efficient body of general rules, one that upholds this notion of justice while also proving more effective in terms of mitigating financial panic.

The link between anti-Bagehotian actions adopted by the Fed and discretionary outcomes is clear throughout the course of the Global Financial Crisis. Lending to or often directly injecting liquidity into insolvent institutions, such as through TARP, the bailouts of Citigroup and AIG, and through alternative facilities, opens the door to outside influences that can dictate tradeoffs in the allocation of credit. The Fed’s implementation of IOER, a consequence of the anti-Bagehotian QE1, disproportionately benefited larger depository institutions while limiting liquidity for smaller banks. This effect was further exacerbated by credit facilities such as the PDCF and TSLF. During the response, viable alternatives that adhered to the Dictum are readily evident and serve to prove the Fed’s capacity to do so, whether it be the Term Auction Facility’s wide-ranging lending practices or QE2’s broad purchasing of Treasury securities. While more literature needs to be written on the rules-based dimension of these programs, they give hope that even if an unprecedented financial crisis similar to the one in 2008 were to emerge in the future, the Fed possesses the necessary arsenal to combat it while adhering to general, rules-based principles that maintain a notion of justice.

Footnotes

[1] Vanberg (2014) writes, “As the term Ordnung (order) is the central concept in the research program of the Freiburg school, it is important to note that, in the context of that program, it is systematically related to the concept of the economic constitution, in the sense of the rules of the game, upon which economies or economic systems are based. As Eucken insists, since all economic activities inevitably take place within some historically evolved framework of rules and institutions, the research-guiding question must be: "What are the rules of the game?"

[2] Illiquidity can be defined as the bank’s inability to meet current debts with its existing supply of liquid assets. Insolvency can be defined as when the bank’s overall, long-term debt exceeds their assets, so that not all promises to lenders can be kept.

[3] On the topic of Bagehot’s individual principles, Boettke et al. (2021, p.100) write that, “each pillar is supported by the two others. Failure to adhere to any one of the rules undermines the efficacy of the rest.”

[4] (Goodfriend 2012) provides commentary on the institutional framework of the 19^th century Bank of England, in which the central bank still adhered to a commodity money system alongside other constraints that the modern Federal Reserve does not adhere to.

[5] See Bernanke (2010, p.8), (2012, p.10), (2013)

[6] Bernanke (2008), in the speech announcing TARP’s creation, states, “On that basis, the Secretary of the Treasury, with the support of the Federal Reserve, went to the Congress to ask for a substantial program aimed at stabilizing our financial markets.” Stewart (2009), meanwhile, discusses the entrepreneurial role Geithner took on.

[7] Calomiris and Khan (2015, p.62-63) write, “With that specific problem (collateralized lending increasing risk levels if lent to insolvent institutions) in mind, the Roosevelt administration implemented a preferred stock program for assistance to financial institutions as part of the Emergency Banking Relief Act of March 9, 1933. Investments of preferred stock were not collateralized, were junior to all bank debt, including deposits, and failure to pay a preferred stock coupon did not force a bank into conservatorship.”

[8] This definition of insolvency is largely synonymous with the one offered in Footnote #2. A common definition of insolvency is offered in the Insolvency Act 1986 (defining it for all United Kingdom commercial and financial activity), which states that an institution is insolvent when it is “unable to pay its debts.” Thus, the criteria for insolvency that Cline and Gagnon (2013) apply to the aforementioned institutions is a widespread one.

[9] George Selgin (2012, p.310) writes that solvent banks, “had the option of turning to the Fed’s discount window, but refrained from doing so owing to the stigma associated with discount window borrowing ever since the Fed’s 1984 bailout of Continental Illinois.”

[10] The Federal Reserve (2020) defines large financial institutions as “U.S. firms with assets of $100 billion or more and foreign banking organizations with combined U.S. assets of $100 billion or more.”

[11] Originally cited from Hummel (2012, p. 186-189).

[12] Gokhale (2012) writes that, “The Fed’s unprecedented earlier rounds of quantitative easing… were designed to accommodate impaired assets with financial institutions, purchasing and holding them until a recovery could begin.” Given that impaired assets often define the line between solvency and insolvency on a balance sheet, this demonstrates a disregard for the Bagehotian principle of lending to solvent banks.

[13] The derivatives market is the market for MBS’s, which are financial derivatives of mortgages. For a discussion on the effects of QE1 and QE3 on real housing prices and mortgage values, see Li (2024).

[14] Craig and Middleton (2017) state that, “Large banks are defined as the top 25 domestically chartered commercial banks ranked by domestic assets. The small banks are all banks not included in the top 25.”

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