Abstract
The banking sector is inherently fragile as it is plagued by a number of market failures (especially those due to information asymmetries); its heavy regulation is justified by the large negative externalities generated by bank failures. Regulatory tools include both ex-ante interventions (legislation and supervision) and ex-post interventions (lending of last resort, bailouts, and deposit insurance). Historically, heavy regulatory frameworks featuring rule-based ex-ante interventions have prevailed in some contexts (e.g. early modern Venice and nineteenth-century United States), while light-touch regulatory frameworks featuring discretionary ex-post interventions have prevailed in other contexts (e.g. nineteenth-century Europe). The heritage of these diverging approaches is still well visible today, as national regulatory frameworks continue to differ substantially.
We have a number of recent examples in our memory (or better, still before our eyes) of the turmoil and great harm that bank failures have inflicted to this city. Noble and affluent houses have been decayed and extinguished; many citizens have been reduced to extreme poverty or greatly battered; unmarried women have been left with no dowry, widows with no subsidy, orphans with no sustenance; merchants have been left weakened, business disordered, and public revenues diminished. […] Which does not happen without somewhat discrediting the state: as in view of the fact that banks had been authorised by decree and continuously supervised by a specifically-appointed and fully-dedicated body, one is led to believe that accidents and failures could not develop without the administration being aware of that.
Tommaso Contarini , Speech to the Venetian Senate in Support of the Creation of a Public Bank, 28 December 1584 (quoted in Lattes (1869, p. 123), my translation and emphasis).
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Notes
- 1.
- 2.
Freixas and Rochet (2008, pp. 15–20 and 146–153).
- 3.
Freixas and Rochet (2008, pp. 4–5).
- 4.
Bank for International Settlements (2016).
- 5.
See, for example, Jacklin (1987).
- 6.
- 7.
- 8.
Diamond and Rajan (2001).
- 9.
See, for example, Grossman (2010, pp. 16–27).
- 10.
- 11.
Goodfriend (1991, pp. 11–12).
- 12.
Kahn and Roberds (2002). For a definition of finality, see Sect. 2.1.1.
- 13.
De Young and Rice (2004).
- 14.
Allen and Gale (2000, pp. 9–10).
- 15.
Freixas and Santomero (2003).
- 16.
A more cynical view (inspired by public choice theory) holds that banking regulation is ubiquitous not because regulators aim at solving market failures , but because they aim at extracting rents : according to this view, because banking would not even be possible without regulatory intervention, extraction is particularly easy in this sector (Calomiris and Haber 2014, pp. 28–34). This view, however, is narrowly focused on limited liability banks. In fact, banking instability and regulation largely predated the introduction of joint-stock banking (see Sect. 3.2.1).
- 17.
- 18.
Rochet and Vives (2004).
- 19.
- 20.
Fetter (1965, pp. 21–23).
- 21.
Grossman and Rockoff (2016, pp. 255–256).
- 22.
Thornton (1802).
- 23.
Hawtrey (1932).
- 24.
Humphrey and Keleher (1984).
- 25.
Bagehot (1873).
- 26.
See esp. Kindleberger (1978).
- 27.
Reference here is to the vast theoretical literature inspired by the modelling of banking panics first proposed by Diamond and Dybvig (1983).
- 28.
“Money will not manage itself” (Bagehot 1873, p. 20).
- 29.
“The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it” (Bagehot 1873, pp. 158–159).
- 30.
“These considerations enable us to estimate the responsibility which is thrown on the Bank of England by our system , and by every system on the bank or banks who by it keep the reserve of bullion or of legal tender exchangeable for bullion ” (Bagehot 1873, p. 121).
- 31.
Bignon et al. (2012).
- 32.
“The public is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made, or on what security it will be made. The best palliative to a panic is a confidence in the adequate amount of the Bank reserve , and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England , both our liability to crises and our terror at crises will always be greater than they would otherwise be” (Bagehot 1873, pp. 206–207).
- 33.
“If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security —on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse” (Bagehot 1873, p. 198).
- 34.
“The end is to stay the panic ; and the advances should, if possible, stay the panic. And for this purpose there are two rules :—First. That these loans should only be made at a very high rate of interest . This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it” (Bagehot 1873, p. 197).
- 35.
“But if the Bank had not made these advances, could it have kept its reserve ? Certainly it could not. It could not have retained its own deposits . A large part of these are the deposits of bankers , and they would not consent to help the Bank of England in a policy of isolation. They would not agree to suspend payments themselves, and permit the Bank of England to survive, and get all their business. They would withdraw their deposits from the Bank; they would not assist it to stand erect amid their ruin” (Bagehot 1873, p. 191).
- 36.
Note that Bagehot thought that such a structure was suboptimal (it was the outcome of government intervention in the sector, which had produced the Bank of England ’s monopolistic position ) and inferior to free banking : “I believe that our system , though curious and peculiar, may be worked safely; but if we wish so to work it, we must study it. We must not think we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one” (Bagehot 1873, p. 20).
- 37.
See, for example, Laidler (2004).
- 38.
- 39.
- 40.
See, for example, Gorton (1988).
- 41.
Hankey (1867).
- 42.
For a survey, see Moore (1999).
- 43.
- 44.
- 45.
Goodfriend and King (1988).
- 46.
Martin (2009).
- 47.
- 48.
Allen and Gale (2017).
- 49.
To be precise, Bagehot recommended the Bank of England to extend both secur itized and non-securitized loans : the former consisted of advances on exchange-traded securities, while the latter consisted of discounts of bills of exchang e. Bills of exchange were idiosyncratic, uncollateralized certificates of corporate indebtedness with multiple guarantee s (see Sect. 2.2.3). They were bought outright by the Bank’s discount window and never reinjected onto the market: Flandreau and Ugolini (2013). Bagehot ’s recommendations under this respect have sometimes been slightly misrepresented by later commentators, who have often translated them as lending on collateral “which is marketable in the ordinary course of business”: see, for example, Hogan et al. (2015).
- 50.
Gorton and Ordoñez (2014).
- 51.
For a survey of this literature, see Allen and Gale (2017).
- 52.
- 53.
See, for example, Morris and Shin (2016). Note that the commonplace translation of the second Bagehot rule as “lend to illiquid but solvent banks” is not truly faithful to the author’s view, as Bagehot was aware of the reverse causation link between illiquidity and insolvency : “The evil is, that owing to terror, what is commonly good security has ceased to be so; and the true policy is so to use the Banking reserve , that if possible the temporary evil may be stayed, and the common course of business be restored”: Bagehot (1873, p. 205), my emphasis.
- 54.
- 55.
- 56.
- 57.
The concept of “market-maker of last resort ” has been first popularized by Buiter and Sibert (2007).
- 58.
Mehrling (2011, pp. 23–29 and 132–135).
- 59.
Hogan et al. (2015, pp. 343–345). Note that in his early criticism of Bagehot’s proposals, Hankey argued that they could have been conducive to moral hazard because they entailed distributional effects not within the financial sector, but between the financial sector and other economic sectors (Hankey 1867, pp. 29–30). To this, Bagehot replied that Hankey’s argument was irrelevant, as the intervention he advocated largely consisted of direct lending to the real sector (not to the financial sector) through the discount of bills of exchange issued by all kinds of firms (Bagehot 1873, p. 172).
- 60.
- 61.
- 62.
“Any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank”: Bagehot (1873, p. 104).
- 63.
- 64.
The term “too-big-to-fail ” was apparently coined in 1984 by Congressman Stewart McKinney in connection to the bailout of Continental Illinois (Gorton 2012, p. 146).
- 65.
Allen and Babus (2009).
- 66.
- 67.
For a survey, see Bongini and Nieri (2014).
- 68.
Brewer and Jagtiani (2013).
- 69.
Some authors even consider that in the absence of “explicit” (i.e. formal) deposit insurance schemes, “implicit” deposit insurance always exists because of the government commitment to organize the bailout of failing banks: see, for example, Demirgüç-Kunt et al. (2015).
- 70.
This is the design adopted in most countries: deposit insurance schemes are mostly funded ex-ante by banks and provided by a fiscal backstop (e.g. a Treasury credit line ) in case of insufficient funding. Exceptions exist, though. For a complete overview, see Demirgüç-Kunt et al. (2015).
- 71.
Diamond and Dybvig (1983).
- 72.
Demirgüç-Kunt et al. (2015).
- 73.
Merton (1977).
- 74.
Dam and Koetter (2012).
- 75.
Laeven (2002).
- 76.
For a survey, see Santos (2006).
- 77.
Calomiris et al. (2016).
- 78.
- 79.
- 80.
Goodhart and Schoenmaker (1995).
- 81.
Blinder (2010).
- 82.
For a survey, see Masciandaro and Quintyn (2016).
- 83.
- 84.
Freshfield (1938).
- 85.
Note that unlimited liability can in itself be interpreted as a barrier to entry : Carr and Mathewson (1988).
- 86.
See Sect. 2.2.1.
- 87.
Mueller (1997, pp. 36–37).
- 88.
- 89.
By contrast, bankers’ cash reserves kept (for safekeeping purposes) in the Treasury ’s safes at Palazzo dei Camerlenghi could be frozen in case of failure and thus used to repay depositors: Mueller (1997, pp. 52–61 and 71–72).
- 90.
See Sect. 2.2.1.
- 91.
Mueller (1997, pp. 151–153).
- 92.
Ferrara (1871, pp. 184–188).
- 93.
Ferrara (1871, pp. 446–449).
- 94.
Ferrara (1871, pp. 449–451).
- 95.
See Sect. 2.2.1.
- 96.
See Sect. 2.2.3.
- 97.
Mueller (1997, pp. 67–69).
- 98.
Mueller (1997, pp. 125–168).
- 99.
Lattes (1869, pp. 14–15).
- 100.
- 101.
Mueller (1997, pp. 126–128 and 163–168).
- 102.
Lattes (1869, pp. 15–17).
- 103.
Lattes (1869, p. 15).
- 104.
Ferrara (1871, pp. 204–211).
- 105.
Lattes (1869, pp. 15–16).
- 106.
Lattes (1869, pp. 16–17).
- 107.
Lattes (1869, pp. 18–20).
- 108.
Lattes (1869, p. 17).
- 109.
- 110.
See Sect. 2.2.2.
- 111.
Schnabel and Shin (2004).
- 112.
Quinn and Roberds (2015).
- 113.
Uittenbogaard (2009, pp. 127–131).
- 114.
See Sect. 2.2.4.
- 115.
Richards (1929, pp. 146–147 and 191–192).
- 116.
Pressnell (1956).
- 117.
See Sect. 2.2.4.
- 118.
Turner (2014, pp. 108–109).
- 119.
Cottrell (2010).
- 120.
Turner (2014, pp. 123–126).
- 121.
Turner (2014, pp. 120–133).
- 122.
Pressnell (1968).
- 123.
Ugolini (2016).
- 124.
Cottrell (2010).
- 125.
Pressnell (1968).
- 126.
Ugolini (2016).
- 127.
Turner (2014, pp. 6–12).
- 128.
Uittenbogaard (2009).
- 129.
Clapham (1944, I, pp. 300–302).
- 130.
Lovell (1957).
- 131.
- 132.
Clapham (1944, I, pp. 300–302).
- 133.
Clapham (1944, II, pp. 93–102).
- 134.
Wood (1939, pp. 90–95).
- 135.
King (1936, pp. 62–70).
- 136.
Wood (1939, pp. 101–103).
- 137.
Clapham (1944, II, pp. 187–189).
- 138.
Wood (1939, pp. 135–143).
- 139.
Bignon et al. (2012).
- 140.
Fetter (1965, pp. 257–258 and 282–283).
- 141.
Hankey (1867, pp. 25–30).
- 142.
“Ready money is a most valuable thing; it cannot from its very essence bear interest – every one is therefore constantly endeavouring to make it profitable , and at the same time to make it retain its use as ready money, which is simply impossible. Turn it into whatever shape you please, it can never be made into more real capital than is due to its own intrinsic value, and it is the constant attempt to perform this miracle which leads to all sorts of confusion with respect to credit. The Bank of England has been long expected to assist in performing this miracle; and it is the attempt to force the Bank to do so which has led to the greater number of the difficulties which have occurred on every occasion of monetary panics during the last twenty years”: Hankey (1867, p. 25). Note that Bagehot based the whole of his argument precisely on the positive observation that, for historical reasons, the Bank of England had come to centralize the country ’s reserves of cash —which was, to him, an inferior situation to free banking from a normative viewpoint: Bagehot (1873, p. 20).
- 143.
Ugolini (2016).
- 144.
Tamagna (1963, pp. 98–99).
- 145.
Fetter (1965, pp. 272–275).
- 146.
Bignon et al. (2012).
- 147.
See Sect. 2.2.3.
- 148.
See Sect. 2.2.3.
- 149.
Flandreau and Ugolini (2013).
- 150.
Flandreau and Ugolini (2014, pp. 87–89).
- 151.
See Sect. 2.2.4.
- 152.
Flores (2011).
- 153.
Chapman (1984, pp. 32–33 and 121–122).
- 154.
Ugolini (2014).
- 155.
Clapham (1944, II, pp. 328–339).
- 156.
- 157.
Turner (2014, pp. 174–180).
- 158.
- 159.
Ugolini (2016).
- 160.
Toniolo and White (2016, pp. 431–433 and 441–442).
- 161.
- 162.
Bignon and Avaro (2017).
- 163.
Roulleau (1914, p. 41).
- 164.
Toniolo and White (2016, pp. 460–461).
- 165.
Jobst and Kernbauer (2016, pp. 176–186).
- 166.
Toniolo and White (2016, pp. 455–467).
- 167.
See Sect. 2.2.5.
- 168.
Grubb (2003).
- 169.
Van Fenstermaker (1965).
- 170.
- 171.
Rockoff (1991).
- 172.
Calomiris (1990).
- 173.
Taus (1943, pp. 16–57).
- 174.
Timberlake (1993, pp. 47–51).
- 175.
See Sect. 2.2.5.
- 176.
White (1983, pp. 10–35).
- 177.
Calomiris (1990).
- 178.
Taus (1943, pp. 68–71, 75–76, 85–93, and 121–128).
- 179.
See Sect. 2.2.5.
- 180.
White (1983, pp. 95–104 and 156–167).
- 181.
- 182.
Flandreau and Ugolini (2013).
- 183.
Generally short of information on borrowers’ creditworthiness, the Feds as a rule discounted paper only up to the amount of capital of the borrowing bank, and required the pledging of additional collateral whenever the amounts discounted exceeded that sum: “As a general principle, the Federal Reserve bank takes the position that a member bank may benefit from its name up to its capital and surplus and may borrow from the Reserve or other banks to that amount without collateral , but beyond that its name is exhausted and further protection is warrantably asked. It may make exceptions of banks in which it has great confidence and lend them beyond capital and surplus without additional collateral, while to others it loans less than this amount on account of its knowledge of the condition of the bank, and the ability of their management; some of the larger banks may have credit much greater than their capital and surplus but they are secured by government bonds ”: Westerfield (1932, p. 49).
- 184.
Bindseil (2004, pp. 121–126).
- 185.
Calomiris et al. (2016).
- 186.
Bordo and Wheelock (2013).
- 187.
Eichengreen and Flandreau (2012).
- 188.
Macey and Miller (1992).
- 189.
Kane (1989).
- 190.
Toniolo and White (2016, pp. 461–463).
- 191.
Toniolo and White (2016).
- 192.
- 193.
See esp. Goodhart (1988).
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Ugolini, S. (2017). Lending of Last Resort and Supervision. In: The Evolution of Central Banking: Theory and History. Palgrave Studies in Economic History. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-48525-0_3
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