VoxEU: The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort (13 August 2007)

When banks were the main providers of credit, the financial stability mandate of central banks could be summarised as their lender of last resort function: in times of crisis, lend freely, at a penalty rate and against collateral that would be good in normal times but may be impaired in times of crisis.1 The counterparties of the central bank in these lender of last resort operations were commercial banks (shorthand for deposit-taking institutions whose main liabilities were deposits withdrawable on demand and subject to a sequential service (first-come, first served) constraint. Their main assets were illiquid loans. This financial structure invited bank runs when confidence in the banks was undermined, for whatever reason. In the days when banks were the dominant intermediaries, a credit crunch or liquidity squeeze manifested itself in the inability of banks to borrow; a lender of last resort that targeted banks was the right vehicle for dealing with liquidity crises and credit squeezes in that set-up.

These days are gone in the globally integrated modern financial systems characterising all advanced industrial countries and an increasing number of emerging markets.

Today, external finance to non-financial corporations and to financial institutions is increasingly provided not through banks but through the issuance of tradable financial instruments directly to the financial markets or indirectly to the financial markets through banks and other financial institutions whose assets are, thanks to securitisation and similar techniques, liquid in normal times.  Now that financial markets (and non-bank financial institutions) have increasingly taken over the function of providing credit and all forms of finance to deficit spending units, a credit crunch or liquidity crunch manifests itself in a different way from the world described by Walter Bagehot's lender of last resort (see Walter Bagehot (1873), Lombard Street: A Description of the Money Market).

Today, a credit crunch or liquidity squeeze manifests itself as disorderly financial markets. Because of pervasive Knightian uncertainty (risk that is perceived as immeasurable and not possible to calculate or quantify), fear and in the limit, panic, little or no trade occurs in certain classes of financial instruments (say subprime mortgage-backed `collateralised debt obligations' CDOs) because there is no market maker with both the knowledge to price these financial instruments and the deep pockets to credibly post buying and selling prices. The precise way in which such micro-market failure (the failure to match willing buyers and sellers at prices acceptable to both) occurs differs for exchange-traded instruments and over-the-counter financial instruments (instruments for which bilateral bargaining over a deal is the normal exchange mechanism), but the solution is the same: the central bank has to become the market maker of last resort.

This was like 3 weeks into the subprime crisis. 5 years into it, the ECB remains at war with central banking.

And, yes, we have 'a run' in the sense that financial intermediation remains broken which, were it not for the globally integrated modern financial systems. 'A run' is a liquidity squeeze, and such things have been known (and continue) to afflict everything from nonfinancial firms to entire national economies during this crisis.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman