‘Ordinary times': Bagehot, liquidity premiums, and the window May 27, 2012 at 9:37 am
FT Alphaville had a good post last week, referencing a new paper by Brad DeLong that in turn discusses the early history of central bank liquidity provision. One paragraph in particular gave me pause for thought:
Bagehot never argued that central banks should lend only against good collateral. Bagehot was subtler than that, and less exclusive. What he argued was that central banks should lend against collateral that would be good “in ordinary times”.
What does this mean? It’s not entirely clear, but I would suggest that a modern version of this doctrine is that as lender of last resort the central bank should advance sums against collateral which are conservative given the expected eventual realised value of the collateral, but it should not consider the market value. Or, to put it another way, the Central Bank should ignore the non-default component of the credit spread in assessing collateral haircuts. That’s a pretty good formulation of the lender of last resort function: central banks should be willing, for a solvent institution, to keep it liquid long enough for it to be able to monetise the spread between assets and liabilities (or for the market to come to believe that that spread is positive, and so be willing to fund the bank privately).