The Puzzling Divergence of the Lender of Last Resort Regimes in the US and UK

Abstract

Central bank lender of last resort (LOLR) regimes are the last line of defence before governments are forced to resort to taxpayer-funded bailouts of the financial system. Yet despite this important role, along with a rich theoretical literature examining the function and design of LOLR regimes, there has been remarkably little comparative research examining the design of these regimes across jurisdictions. This paper seeks to close this gap by tracing the historical development of the LOLR regimes in two jurisdictions at the heart of the global financial system: the US and UK. This historical record reveals an important and intriguing puzzle. Despite deeply-rooted similarities in their legal, political, and economic systems, the LOLR regimes in the US and UK have evolved at remarkably different speeds and, increasingly, in different directions. Even more remarkably, cutting against the global trend toward greater regulatory harmonization, this divergence has actually accelerated in the decade following the global financial crisis.

Having traced the historical development of the LOLR regimes in the US and UK, this paper seeks to explain this puzzling divergence. Three potential explanations stand out. First, while debates about the function and design of LOLR regimes almost universally revolve around the writings of 19th century journalist Walter Bagehot, the subsequent 150 years have witnessed the emergence of two distinct schools of thought on financial crisis management. While US policymakers have been heavily influenced by the highly theoretical ‘monetarist’ school, their counterparts in the UK have been influenced by the more pragmatic ‘financial stability’ school. Second, differences in the political culture of the US and UK, along with the domestic political economy of financial regulation, have put very different pressures on policymakers responsible for the design and use of LOLR regimes. Third, and perhaps most importantly, the US and UK have vastly different historical experiences with financial crisis management. Most importantly, while the frequent crises of the 19th century left the Bank of England deeply skeptical of strict legal constraints on LOLR regimes, US policymakers have embraced precisely these type of constraints in response to the financial crisis. This last explanation has potentially enormous implications for US policy: suggesting that its new LOLR regime will buckle — and potentially break — under the strains of the next crisis.

Keywords: Financial crisis, lender of last resort, emergency liquidity assistance, financial safety net, Federal Reserve, Bank of England, Dodd-Frank Act, Sterling Monetary Framework

JEL Classification: E02, E42, E44, E58, K22, K23, N21, N22, N23, N24