Crisis prompted both ‘re-discovery' and overhaul of CBs' emergency liquidity

The financial crisis led to a "re-discovery" of emergency liquidity, a critical part of a central bank's lender-of-last-resort (LOLR) function that was first outlined by Walter Bagehot in his 1873 classic work Lombard Street, as New York Fed vice-president Thomas Baxter told an audience in Madrid last week.

During the crisis, central banks used "Bagehot's old saw", lending freely into a panic "at a very high rate of interest" and against good collateral, Baxter said, invoking the Fed's $85 billion loan to AIG in particular.

But he added that the crisis also altered the conduct of liquidity operations – a result of "evolving policy views and changes in the law". For instance, Dodd-Frank prohibits emergency lending to a non-bank to save it from bankruptcy.

In addition, Baxter suggested that greater sensitivity among central banks to the risk of financial loss – the result of greater public scrutiny – "might conflict with the policy imperative that Bagehot articulated, namely a massive liquidity injection to calm a growing financial panic."