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Solvency as a Fundamental Constraint on LOLR Policy for Independent Central Banks: Principles, History, Law

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Abstract

This paper follows up earlier work advocating a principled modernization of doctrines for central bank lender-of-last-resort policies and operations. It argues for a new Fundamental Constraint on such authorities: namely, "the principle that central banks should not lend to firms that they know (or should know) to be fundamentally bust or broken." Tucker supports this with commentary from various peers, a review of principles underlying bankruptcy law and resolution schemes, and by deconstructing other common counterarguments. Centrally, he argues that when central banks breach the Fundamental Constraint, they distribute resources to short-term creditors at the expense of longer-term creditors, acting as though they are the elected fiscal authority, and so violating some of the deepest values of constitutional democracy as well as jeopardizing their own independence. Using examples from canonical 19th century crises and the Lehman episode during 2008/09 Great Financial Crisis, he illustrates how the Fundamental Constraint can help make sense of certain decisions, and how it should shape a re-articulation of the published policies of the Federal Reserve and European Central Bank.

Suggested Citation

  • Tucker, Sir Paul, 2020. "Solvency as a Fundamental Constraint on LOLR Policy for Independent Central Banks: Principles, History, Law," Journal of Financial Crises, Yale Program on Financial Stability (YPFS), vol. 2(2), pages 1-33, April.
  • Handle: RePEc:ysm:ypfsfc:2211
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    References listed on IDEAS

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    1. Paul Tucker, 2014. "The lender of last resort and modern central banking: principles and reconstruction," BIS Papers chapters, in: Bank for International Settlements (ed.), Re-thinking the lender of last resort, volume 79, pages 10-42, Bank for International Settlements.
    2. Ball,Laurence M., 2018. "The Fed and Lehman Brothers," Cambridge Books, Cambridge University Press, number 9781108420969, January.
    3. Thomas M. Humphrey, 2010. "Lender of Last Resort: What It Is, Whence It Came, and Why the Fed Isn't It," Cato Journal, Cato Journal, Cato Institute, vol. 30(2), pages 333-364, Spring.
    4. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 84(3), pages 488-500.
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    More about this item

    Keywords

    LOLR; solvency; lehman; independent central bank; federal reserve; bagehot; bank of england;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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