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Number 95-21, May 26, 1995

Financial Fragility and the Lender
of Last Resort
Financial crises, such as banking panics and
stock market crashes, were a common occurrence in the
economy before World War II.
Since then, financial crises have been less common. However, events of the past decade have
led to renewed concerns about financial instability and about the proper role of monetary
policy in reacting to financial turbulence.


This Weekly Letter provides some background
on the nature of financial crises, and it discusses
whether and how policymakers should intervene.
Our discussion borrows heavily from papers by
Frederic Mishkin (1991, 1994). Because there are
costs to inappropriate intervention, Mishkin suggests that the central bank should intervene only
when certain informational problems make it difficult for financial markets to efficiently channel
funds to productive investment opportunities. A
conceptual framework is needed in order to determine when these informational problems arise.
This Letter discusses a framework that is based
upon theories of asymmetrical information, and
it describes the trade-offs that policymakers face.

Theories of financial crises
The traditional theory of financial crises focuses
on the effects of bank runs on the money supply.
Other things equal, bank runs tend to reduce
the money supply by increasing the public's desire to hold currency and banks' desire to hold
reserves. Unless the central bank reacts by increasing the supply of currency and reserves,
the money supply would fall and interest rates
would rise, thus reducing the public's spending
on goods and services. For example, Milton
Friedman and Anna Schwartz (1963) argue that
the Federal Reserve's inaction during the banking
panics of the early 1930s helped turn an ordinary
recession into the Great Depression. They argue
that the Federal Reserve should intervene in a
banking panic in order to prevent a contraction
in the money supply.
In addition to this effect, modern theories of financial crises focus on the consequences of asym-

metrical information between borrowers and
lenders. Borrowers generally know more about
their investment projects than lenders, and this
can lead to problems related to adverse selection
and moral hazard.
Adverse selection occurs when events cause lowrisk borrowers to drop out of credit markets. Borrowers invest in projects that involve various
payoffs and degrees of risk. High-risk projects
also tend to have high expected returns. If lenders do not have enough information to assess the
risk-return tradeoffs of particular projects, they
must extend credit at an interest rate that reflects
the average risk of the market. The average interest rate is too high for projects with low risk
and expected return, and it is too low for highrisk, high-return projects. Thus asymmetrical information tends to push low-risk borrowers out
of credit markets, leaving only the high-risk
Asymmetrical information can also give rise to
moral hazard. Once a borrower has received
credit, he may have an incentive to undertake
activities which raise his own expected return
but which also increase the probability of default. This is especially problematic when credit
takes the form of a debt contract that allows for
bankruptcy and when lenders have difficulty
monitoring the borrower's activities.
To mitigate adverse selection and moral hazard
problems, Stiglitz and Weiss (1981) show that
lenders might prefer to ration credit rather than
to raise interest rates when credit demand or
uncertainty increases. If lenders were to raise
interest rates when credit demands or uncertainty increased, low-risk, low-return borrowers
would drop out of the credit market, and highrisk, high-return borrowers would remain. Thus,
if creditors were to increase interest rates, the
riskiness of the pool of borrowers would increase.
Therefore, lenders may choose not to raise interest rates and may instead choose to supply
less credit than borrowers demand at the going

interest rate. Thus, borrowers who have profitable
investment opportunities may be unable to find
Mishkin defines a financial crisis as a situationĀ·
in which adverse selection and moral hazard
problems become much worse, so that financial markets are unable to channel credit to borrowers with profitable investment opportunities.
Clearly, this definition does not apply in which creditors can easily evaluate the
riskiness of projects and monitor the behavior
of investors. But in markets where information
is asymmetrical, financial crises are costly, because they reduce economic efficiency and
because they may lead to a sharp reduction in
investment and aggregate demand. Finally, note
that a market crash does not by itself constitute a
crisis. A crash could reflect a sharp, adverse turn
in fundamentals, as in May 1940 when the
stock market crashed after the fall of France.


Symptoms of financial crisis
To identify a crisis, policymakers must determine
whether adverse selection or moral hazard problems have become critical. Mishkin lists a number of symptoms. One is a sharp increase in
interest rates. This tends to push low-risk borrowers out of credit markets and may lead to credit
Another symptom is a sharp, unexpected decline in stock prices or inflation. This exacerbates
asymmetrical information problems because it
reduces the net worth of firms that seek credit.
Bernanke and Gertler (1989) show how a large
decline in borrower net worth can increase adverse selection and moral hazard problems. A
firm's net worth performs a role that is similar
to collateral, since a lender can take title to a
firm's assets in case of default. Collateral mitigates adverse selection and moral hazard problems because it reduces the lender's losses if the
borrower defaults. A decline in net worth implicitly reduces the value of a firm's collateral and
may tighten credit rationing.
A third symptom is a banking panic or the failure
of other financial institutions. Banks specialize
in processing information about borrowers and in
monitoring their activities. For example, they usually engage in long-term relationships with their
customers, and can monitor their customers' behavior by overseeing their checking account or
credit line activity. Bank services are valuable
because they reduce the degree of information
asymmetry between borrowers and individual

savers, who are the'ultimate lenders. During a
panic, bank failures increase the degree of information asymmetry. Furthermore, banks that
remain in business seek to protect themselves by
increasing reserves relative to deposits, and this
also results in a reduction of lending.
A fourth symptom is an increase in the spread
between interest rates on high- and low-quality
bonds. This spread reflects the difference in
default risk on well-known, high-quality borrowers (such as the
Treasury) and lesserknown, lower-quality borrowers. Hence, this
interest rate spread tends to widen when asymmetrical information problems become severe.
Historically, "this has proven to be a relatively
reliable indicator.


Implications for monetary policy
The classical policy prescription in the event of a
financial panic is for the central bank to act as
a lender of last resort. In a narrow sense, this can
be justified on monetarist principles. Bank fail;.
ures are contractionary because they reduce the
stock of money. Thus, during a banking panic,
the central bank should lend through the discount window or engage in open-market purchases in order to prevent a contraction in the
supply of money. .
The asymmetrical information theory suggests
a broader perspective. There may also be occasions when the central bank may need to provide
lender-of-Iast-resort services to nonbanking firms
as well. This can be done through the discount
window, but other policy actions also may have
a role. For example, in June 1970, when Penn
Central defaulted on more than $200 million in
commercial paper, the Federal Reserve became
concerned that at a time when financial markets
were already unsettled, the liquidity of the commercial paper market might be impaired and the
pressures arising in that market might spill over
to other short-term credit markets. The Federal
Reserve moved to suspend the maximum interest
rate ceilings on large-denomination time deposits
with maturities of 30 to 89 days imposed by Regulation Q. This made it easier for private banks
to serve as intermediaries. Investors reluctant to
lend to the commercial paper market now provided additional funds to the private banking
sector, and borrowers unable to roll over their
commercial paper were provided with this new
source of credit. The Fed also increased liquidity
in the commercial paper market by allowing
banks to borrow at its discount window (see
Board of Governors, 1971).

The stock market crash of 1987 provides another
example of a successful intervention and illustrates the value of lender-of-Iast-resort activity.
On Monday, October 19th, the Dow Jones Industrial Average fell by 22 percent. The day after
the crash, many securities firms and exchange
specialists needed credit to finance inventories
of stocks whose value had fallen sharply. Also,'
many investors were asked to provide more collateral for securities bought on credit. These
demands, known as margin calls, occur when
the value of equities in an investor's account fall
below a set minimum. Since the value of collateral had fallen sharply, banks were increasingly
reluctant to lend. The interest rate spread between junk bonds and Treasury bills jumped by
130 basis points during the week of the crash and
rose by another 60 basis points over the following two weeks. The presence of both the stock
market crash and the increase in the spread of
interest rates between high- and low-quality
bonds indicates that asymmetrical information
may have increased in the securities sector.

financial crisis. Because of these costs, lenderof-last-resort activity should probably be used

The Federal Reserve became concerned about
a possible systemic breakdown in the market's
clearing and settlement systems, and it announced a readiness to "serve as a source of
liquidity to support the economic and financial
system:' The Federal Reserve then proceeded to
accommodate the increase in demand for liquidity in the economy by buying government
securities on the open market. This provided
banks with the extra reserves they needed to
extend credit to the securities dealers. The Fed
also tried to maintain a high level of visibility in
the financial markets to help calm fears of a potential crisis. The Fed placed examiners in major
banking institutions to monitor banking developments, and also closely monitored securities
firms' demands for credit (Greenspan 1988).

Bernanke, Ben, and Mark Gertler. 1989. "Agency
Costs, Net Worth, and Business Fluctuations:'
American Economic Review 79, pp. 14-31.

While lender-of-Iast-resort activity may help protect against financial crises, there is a cost. If
depositors know that the central bank will bail
private banks out if their loans go bad, they may
have less incentive to monitor the riskiness of
the banks' portfolios. Likewise, if nonbanking institutions know that the central bank will step in
during a financial crisis, they might take on more
risks that are associated with an economy-wide

Theories based on asymmetrical information suggest that financial markets can be fragile, since
lenders may opt out of the market when credit
demands increase or when uncertainty is especially great. By serving as a lender of last resort,
central banks can play an important role in reducing financial panics, as they can ensure that
credit markets remain liquid in the event of a crisis. However, this literature suggests that central
banks should intervene sparingly, as too much
involvement may cause market participants to
assume more risk.

Desiree Schaan
Research Associate

Timothy Cogley
Senior Economist


Board of Governors of the Federal Reserve System.

1971. Annual Report, 1970.
Friedman, Milton, and Anna Schwartz. 1963. A Monetary History of the United States. Princeton:
Princeton University Press.
Greenspan, Alan. 1988. "Statement before the Committee on Banking, Housing, and Urban Affairs,
February 2, 1988:' Reprinted in the Federal Reserve Bulletin (April), pp. 217-225.
Mishkin, Frederic S. 1991. "Asymmetric Information
and Financial Crises: A Historical Perspective:' In

Financial Markets and Financial Crises, A National
Bureau of Economic Research Project Report, ed.
R. Glenn Hubbard, pp. 69-108. Chicago: University of Chicago Press.

_ _ _ _.1994. "Preventing Financial Crises; An
International Perspective:' NBER Working Paper
No. 4636.
Stiglitz, Joseph, and Andrew Weiss. 1981. "Credit
Rationing in Markets with Imperfect Information:'
American Economic Review 71, pp. 393-410.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor
or to the author. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal
Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Weekly Letter
texts and other FRBSF publications and data are available on FedWest Online, a public bulletin board service reached by setting
your modem to dial (415) 896-0272.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper Q

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Index to Recent Issues of FRBSF Weekly Letter









The Development of Stock Markets in China
Effects of California Migration
Gradualism and Chinese Financial Reforms
The Credibility of Inflation Targets
A Look Back at Monetary Policy in 1994
Why Banking Isn't Declining
Economy Boosts Western Banking in '94
What Are the Lags in Monetary Policy?
Central Bank Credibility and Disinflation in New Zealand
Western Update
Reduced Deposit Insurance Risk
Rules vs. Discretion in New Zealand Monetary Policy
Mexico and the Peso
Regional Effects of the Peso Devaluation
1995 District Agricultural Outlook
Has the Fed Gotten Tougher on Inflation?
Responses to Capital Inflows in Malaysia and Thailand
Financial Liberalization and Economic Development
Central Bank Independence and Inflation
Western Banks and Derivatives
Monetary Policy in a Changing Financial Environment
Inflation Goals and Credibility
The Economics of Merging Commercial and Investment Banking


The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.