Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Lender of Last Resort Powers
Transcript
- Lucas: So it's June 2026, and we're in a period where central banks are not exactly in crisis mode—but the memory of 2023 is still very fresh. And there's one central bank tool that only gets attention when things are going really wrong: the lender of last resort function. Luna: Right—the emergency lending power. We talk a lot about open market operations, interest on reserves, forward guidance. But the lender of last resort is the emergency room. It's not routine. Lucas: Exactly. And the classic framework for this goes back to Walter Bagehot, a 19th-century British journalist who wrote 'Lombard Street' in 1873. His prescription was simple: in a panic, lend freely, at a high rate, against good collateral. That's basically the template central banks have used ever since—or at least, they cite it. Luna: But the 2008 crisis and the 2023 regional bank crisis showed that central banks sometimes deviate from that script. Let's talk about why. Lucas: Let's start with Bagehot's first principle: lend freely. The idea is that during a bank run, you don't want to be stingy. If banks know the central bank will provide liquidity, they stop hoarding cash. But 'lend freely' is easier said than done, because the central bank has to decide: is this a liquidity problem or a solvency problem? Luna: That's the $64,000 question. If a bank is just illiquid—it has good assets but can't sell them quickly without a fire sale—then lending freely makes sense. But if the bank is insolvent, its liabilities exceed its assets, and lending just throws good money after bad. Lucas: Bagehot said lend to 'anyone who can provide good collateral.' But what counts as good collateral changes over time. In 2008, the Fed started accepting mortgage-backed securities that were suddenly very hard to value. And in 2023, with the Silicon Valley Bank failure, the Fed created the Bank Term Funding Program, which accepted Treasury bonds and agency debt at par—even though their market value had fallen. Luna: That was a big departure. Normally, the discount window applies a haircut—meaning the Fed lends less than the collateral's market value. But the BTFP lent at par. So if a bank had a $100 Treasury bond that was only worth $90 on the market, the Fed still lent $100. Lucas: Exactly. And the reason was that SVB's problem was an interest rate mismatch. They had bought long-term Treasuries when rates were low, then rates shot up, and the market value of those bonds collapsed. But if the bank held them to maturity, they'd get $100 back. So the Fed basically said: we'll lend you the full face value, not the panic price. Luna: That effectively stopped a run on other regional banks. But it also raised the moral hazard question—if banks know the Fed will bail them out on generous terms, will they take more risk? Lucas: And that's the tension central banks have wrestled with for over a century. Bagehot himself said the high rate was meant to penalize borrowers and discourage frivolous use. The classic discount window rate is above the market rate—so it's a punishment rate. But in 2008 and again in 2023, the Fed lowered that penalty to make borrowing less painful. Luna: Let's zoom in on 2008 for a moment. Bear Stearns was rescued in March 2008 via a Fed loan to JPMorgan to buy Bear. Then Lehman Brothers was allowed to fail in September. Why the inconsistency? Lucas: Great question. Bear Stearns was deemed too interconnected to fail suddenly. The Fed used a creative backdoor—lending through JPMorgan, because the Fed can't directly lend to investment banks under normal authority. For Lehman, the calculation was different: Lehman's books were much messier, and the Fed and Treasury felt they had to send a message that not every firm would be saved. Of course, the aftermath—the AIG rescue, TARP, the whole panic—showed that letting Lehman fail made things worse. Luna: So in practice, the lender of last resort function is rarely applied mechanically. It involves judgment calls about systemic risk, collateral quality, and moral hazard. Lucas: Right. And there's another layer: stigma. Banks hate borrowing from the discount window because it signals weakness. So during the 2008 crisis, the Fed created the Term Auction Facility, which let banks bid anonymously for loans. That reduced stigma. In 2023, the BTFP was similarly designed to be less stigmatizing—banks could borrow without revealing themselves. Luna: But some banks still didn't use it. First Republic, for example, ultimately failed despite having access. So stigma isn't the only issue—sometimes the hole is just too deep. Lucas: Exactly. And that brings us back to the solvency question. If a bank's losses are so large that even a par loan can't save it, then lender of last resort just delays the inevitable. That's why central banks also have resolution authorities—like the FDIC—to step in when a bank is insolvent. Luna: You know, talking about all these emergency tools makes me realize how much trust the system depends on. The Fed can lend trillions, but if depositors don't believe it's enough, they still run. Lucas: That's the psychology at the heart of banking. And the lender of last resort is ultimately a confidence mechanism. If people know the central bank will backstop the system, they don't need to withdraw. The challenge is making that commitment credible without encouraging reckless behavior. Luna: And I think that's why episodes like this are important. Understanding these tools helps people see through the headlines. If walking through the economy with us has made something click, we'd love to know. We keep this show ad-free on purpose—no sponsors, no interruptions. If you value that, supporting us is simple. The link is buy me a coffee dot com slash fexingo. That's it. Lucas: Yeah, listener support is what keeps this going. No pressure, but every bit helps us keep producing episodes like this one. So thank you to anyone who's pitched in. Luna: Alright, back to the lender of last resort. One more angle I want to touch on: the role of international coordination. During the 2008 crisis, the Fed set up swap lines with other central banks to provide dollars globally. That's essentially the Fed acting as lender of last resort to the world. Lucas: Right—dollar swap lines. Because many banks outside the US had dollar-denominated liabilities but couldn't easily get dollars. The Fed provided dollars to the European Central Bank, the Bank of England, the Bank of Japan, and others, who then lent to their local banks. That was unprecedented in scale. Luna: And those swap lines were reactivated in March 2020 and again in March 2023, though on a smaller scale. So they've become a standing tool, not just a one-off crisis measure. Lucas: Exactly. And that raises a question: is the lender of last resort function expanding permanently? The Fed is now more willing to lend against a wider range of collateral, to a wider range of institutions, with less stigma. Some economists worry that this creates moral hazard on a systemic level. Luna: But others argue that the alternative—letting a systemically important institution fail—is worse. It's a classic central bank dilemma. Lucas: And it's one that doesn't have a perfect answer. Bagehot's rules were designed for a world of small, simple banks. Today's financial system is vastly more complex, with shadow banking, derivatives, and global interconnectedness. The lender of last resort has had to evolve. Luna: So when we look at central bank balance sheets today—still elevated from the pandemic, still holding lots of bonds—the lender of last resort function is kind of always latent. The Fed is ready to lend at any time. Lucas: Right. In fact, the discount window is always open. The rate is set—right now it's the top of the Fed's target range. But banks rarely use it in normal times because of stigma. The challenge for central bankers is to normalize emergency tools so they're available when needed, but not abused. Luna: One idea that's been floated is to make the discount window more like a standing facility—always available, with a clear rate and collateral terms, so that using it isn't seen as a sign of weakness. The Fed has been trying to reduce stigma by encouraging banks to test access. Lucas: Yeah, they've been running 'discount window readiness' exercises. In 2024 and 2025, the Fed pushed banks to pre-position collateral and test borrowing. The idea is that if banks are used to tapping the window in calm times, they won't hesitate in a panic. Luna: That's a smart approach—practice for the real thing. But it's a hard sell for bank executives who worry about shareholder perception. Lucas: Absolutely. And that's where culture change meets monetary policy. The lender of last resort is ultimately about rules and norms. Bagehot gave us the rules, but the norms are still being written. Luna: So where does that leave us? If another crisis hits tomorrow, do we know how the Fed will react? Lucas: We know the tools: discount window, btfp style programs, swap lines, emergency lending under Section 13 of the Federal Reserve Act. But the specific application will depend on the nature of the crisis. The lesson from 2008 and 2023 is that central banks will be creative and aggressive. The question is whether they'll be too aggressive, creating moral hazard, or not aggressive enough, letting a panic spread. Luna: And that balance—that's the art of central banking. Thanks, Lucas. Lucas: Thanks, Luna. Until next time.