Implementing Bagehot’s rule in a world of derivatives: the Banque de France as a lender of last resort in the nineteenth century
The expansion of the scope and size of the Federal Reserve’s operations to halt the Meltdown of 2008 violated Bagehot’s lender of last resort rules for central banks. In increasingly complex and diverse financial markets, where derivatives have a vital role, it was argued that Bagehot’s traditional principles had to be jettisoned. Based on the experience of the nineteenth century Bank of England, it appeared that Bagehot had prescribed rules that were too narrowly focused on banking. History would appear to be no guide. However, across the channel, at the same time that Bagehot was writing, the Banque de France operated in a very different financial system. In France, shocks frequently emanated from the stock exchanges where the dominant instrument was a derivative – a forward contract. Crashes in asset values ignited waves of broker defaults on the Paris Bourse and other exchanges, threatening the settlement of contracts and producing a more general liquidity crisis. After recurrent crises, the Banque adopted policy rules that Bagehot would certainly have approved and successfully navigated severe liquidity shocks originating on the exchanges. The Banque’s regents were adamant that its principles should not be abandoned when providing liquidity to the markets, no matter how severe the crisis. By the last quarter of the nineteenth century, the Banque refused bailouts; instead, it freely provided liquidity against the highest quality collateral at a high interest rate. Thus in 1882, the solvent Bourse de Paris received an emergency loan to manage an extraordinarily difficult end-of-month settlement, but the insolvent Bourse de Lyon was allowed to fail. In the 1896 crash, individual brokers with good collateral received advances while those without were excluded and failed. On both occasions, many investors in the forward market were ruined by the collapse of equity prices, yet the liquidity of the exchanges was quickly restored. The long depression that followed the 1882 crash was not a consequence of damage to the capital and money markets but excessive investment in low quality assets during a long expansion. Using the minutes of the Conseil Général of the Banque de France, this paper examines in detail how this central bank acted as a lender of last resort in an environment where shocks to the financial system came from rapid declines in asset values that caused customers to default on their derivatives contracts, leading to broker defaults on the exchanges and the over-the-counter markets.