Did Bernanke’s Fed Follow Bagehot’s Rules?

How should central banks behave during a financial crisis? Up until very recently, the conventional wisdom was that the guidelines provided by Walter Bagehot, a 19th-century British journalist and businessman, were the best way to nip a crisis in the bud. The following are a good approximation of Bagehot’s recommendations for central banks in their capacity as lenders of last resort:

1. Central banks should lend on any regularly traded and familiar collateral.
2. Central banks should lend freely, but at a penalty—that is, above-market—rate of interest.
3. Central banks should announce their intent to follow these policies beforehand, so as to anchor public expectations.

Is this how the Fed actually behaved during the 2008 crisis? Ben Bernanke, then chairman, certainly seemed to think so. For example, at a public lecture in 2012, Bernanke claimed that “the Federal Reserve, responding in the way that Bagehot would have had us respond, established special programs. Basically, we stood as backstop lenders. We said: ‘Make your loans to the — these companies, and we’ll be here ready to backstop you if there’s a problem rolling over these funds.’”

As it turns out, the above statement is simply not credible. Ben Bernanke’s Fed pursued extensive and unprecedented policies during the crisis that beared little resemblance to Bagehot’s rules.

First, the Fed did not lend only on regular and familiar collateral. Many of the assets the Fed treated as collateral for its loans to financial organizations were unusual, such as the now-infamous mortgage-backed securities and other exotic assets. Furthermore, the Fed also engaged in outright purchases of questionable assets, attempting to shore up the health of banks’ balance sheets by swapping their risky and difficult-to-value assets for safe assets. Whatever the merits of this approach, it greatly exceeded the lending guidelines provided by Bagehot.

Second, while the Fed did set its discount rate (the rate at which financial organizations can borrow from the Fed) above its target for the federal funds rate in the run-up to the crisis, once financial markets started experiencing significant turbulence in 2007, the Fed started to shrink this spread. The Fed also extended borrowing windows from 30 to 90 days. In addition, the Fed engaged in unusual discounting activities when it began a new program to loan directly to the so-called primary dealers, those financial organizations the Fed relies on in implementing monetary policy.

Third, these activities were unprecedented and ad hoc. Collectively they represented no known principle of central bank behavior during the crisis. Defenders will assert that this was necessary to prevent the meltdown of the U.S., and by extension the global, financial system. Whatever the merits of that defense, it does not change the fact that these activities of the Fed were nearly the opposite of Bagehot’s advice regarding public foreknowledge and Fed commitment. Bailing out Bear Stearns but not Lehman is case in point as a decision the Fed made in the heat of the moment that was difficult for the market to understand.

Bagehot’s rules are ultimately geared toward assisting illiquid financial organizations but allowing insolvent ones to fail. The Fed went out of its way to support insolvent organizations — those that loaded up on unfamiliar and risky assets in an irresponsible manner. But instead of allowing these organizations to fail while acting only to prevent a system-wide liquidity crunch, the Fed engaged in widespread protection of what were essentially politically important financial organizations. Bernanke’s Fed did not follow Bagehot’s rules, based on any reasonable interpretation of those rules.

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