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Working Paper Series

Limited Commitment and Central Bank
Lending

WP 99-02

Marvin Goodfriend
Federal Reserve Bank of Richmond
Jeffrey M. Lacker
Federal Reserve Bank of Richmond

This paper can be downloaded without charge from:
http://www.richmondfed.org/publications/

Limited Commitment and Central Bank Lending

Marvin Goodfriend and Jeffrey M. Lacker∗

January 26, 1999
Federal Reserve Bank of Richmond Working Paper 99-2

Abstract: Central bank or International Monetary Fund lending should be regarded as a
line of credit, analogous to private line-of-credit products. Contractual provisions in
private line-of-credit arrangements are designed to control managerial moral hazard and
provide a means for profit-maximizing lenders to credibly commit to withdraw credit and
induce closure when appropriate. The contractual mechanisms utilized by private line-ofcredit providers are not effective for a central bank whose primary mission—to maintain
financial system stability—can override its obligation to protect public funds and
undercut its ability to limit its lending reach. We consider in some detail five broad
approaches to a central bank’s commitment problem: good offices only, collateralization
and early intervention, constructive ambiguity, extending supervisory and regulatory
reach, and reputation building. Our analysis suggests that the first four institutional
approaches cannot be counted on to overcome the fundamental forces inducing a central
bank to lend. We argue that the only practical way for a central bank to credibly limit
lending is for it to build up over time a reputation for restraint.
JEL Classification: E44, E58, F33
Keywords: central banks, International Monetary Fund, discount window, lender of last
resort, loan commitments, moral hazard, reputation, constructive ambiguity, financial
stability

∗

Paper prepared for the Second Joint Central Bank Research Conference on Risk Measurement and
Systemic Risk at the Bank of Japan, Tokyo, November 16-17, 1998. Correspondence: Federal Reserve
Bank of Richmond, P.O. Box 27622, Richmond, Virginia, 23261, USA, e-mail:
JEFFREY.LACKER@RICH.FRB.ORG. The authors are grateful for the comments of Urs Birchler and Doug
Diamond on an earlier draft. The authors’ views do not necessarily represent those of the Federal Reserve
Bank of Richmond or the Federal Reserve System.

Central bank lending is widely regarded as a vital part of the public safety net supporting
the stability of the banking system and financial markets more generally. A central bank
that is financially independent and has a sizable portfolio of government securities can
provide large amounts of liquidity to institutions on very short notice.1 Indeed, central
bank lending has been a prominent part of regulatory assistance to troubled financial
institutions in recent years. The idea that a central bank should be a lender of last resort
has been around at least since Walter Bagehot wrote about it over one hundred years ago.
For most of that hundred years it was taken for granted that central bank lending
had benefits with little or no cost. That view has been challenged recently. For instance,
in the United States the Federal Deposit Insurance Corporation Act (FDICA) of 1991
recognized that Federal Reserve (Fed) lending to undercapitalized banks has the potential
to impose higher resolution costs on the Federal Deposit Insurance Corporation (FDIC).
More recently, the idea that lending by the International Monetary Fund (IMF) has led to
increased risk-taking in international financial markets is being taken seriously by
financial market participants and policymakers alike.2 In the United States, financial
economists have acknowledged “moral hazard” to be a problem for government financial
guarantees ever since the savings and loan crisis of the 1980s.
In this paper we take a closer look at central bank lending in light of the concerns
mentioned above. Our aim is a practical one: we wish to present some principles to help
guide central bank lending policy. Our conceptual framework builds on the observation
that central bank lending is a publicly provided line-of-credit service. There is a
fundamental commonality between commercial bank lines of credit and central bank
lending because both involve the advancement of large amounts of funds on short notice.
Line-of-credit products are complex. We make use of recent advances in the
theory of financial contracts to interpret the structure of loan commitments. By
dissecting the incentive implications of the contractual obligations and rights involved in
lines of credit, we develop an appreciation of the tensions involved in offering credit
lines. In particular, we see how contract terms control the ex post incentives of the
borrower and the lender under limited commitment to assure that the line-of-credit
product is efficient. We then employ our understanding of these issues to benchmark and
inform our consideration of central bank lending.
The nature of the problem is this: A line-of-credit product is designed to meet the
current obligations of a firm when it is judged to be illiquid though solvent. Inevitably,
then, a loan commitment shifts potential losses from short- to longer-term claimants. For
instance, a line of credit to an ordinary business has the potential to shift losses to the
1

Because a central bank can create money, it has the option of financing lending with an increase in the
money supply. We would call such lending a combination of monetary policy and credit policy. When we
speak of central bank lending in this paper, however, we confine ourselves to pure credit policy. Pure
central bank credit policy finances loans with proceeds from the sale of securities (Goodfriend and King
1988).
2
Strictly speaking the International Monetary Fund is not a central bank since it does not have the power to
create money. Nevertheless, financially it is a relatively independent governmental organization, and it
does make large loans on relatively short notice to countries in financial distress (Masson and Mussa 1995).

2

borrowing firm’s long-term bondholders. And a central bank’s line of credit has the
potential to shift losses from uninsured creditors to the deposit insurance fund or general
taxpayers. Likewise, lending by the IMF to finance a country’s balance of payments
deficit has the potential to shift losses from short-term investors in that country to that
country’s taxpayers. Covenant provisions in private line-of-credit agreements give
lenders the ability and the incentive to constrain credit to insolvent firms, limiting moral
hazard. In contrast, central banks appear to lack explicit institutional mechanisms to
credibly precommit to limit lending. Thus, an excessively liberal central bank line of
credit makes short-term capital more inclined to move in the direction of favorable yield
differentials irrespective of the risk involved, with the idea that a credit line could finance
a quick withdrawal.
The inability to commit to limit lending is the principle weakness of central bank
lending policy. The problem is that central banks responsible for the stability of the
entire financial system are inclined to lend whenever not lending could plausibly trigger a
systemic crisis. That inclination encourages both domestic and international short-term
“hot money” investments and increases the scope for violent reversals and flights to
safety whenever the market begins to doubt central bank lending intentions. While we
are agnostic about whether there is a positive welfare-enhancing role for central bank
lending, our premise is that the critical policy problem is how to limit central bank
lending to socially appropriate circumstances.
The paper is structured as follows. Section 1 contains a detailed description of the
structure and mechanics of private lines of credit. Central bank lending is characterized
as a line of credit in Section 2, and the line-of-credit analogy is exploited to identify the
nature and source of the undesirable consequences of lending by central banks. In
Section 3, we consider how well some actual and possible components of central bank
lending policy cope with the fundamental problem mentioned above. We conclude that
no simple institutional mechanisms could confidently precommit a central bank to limit
its lending. Reasoning by analogy to the inflation problem, we argue that the only
practical way for a central bank to credibly commit to limit its lending is for it to build up
a reputation over time for not lending. Exploiting the inflation analogy further, we
describe a sequence of events that is likely to have to take place for a central bank to
succeed in acquiring a reputation to limit its lending.

1. The Economics of Private Lines of Credit
There is a fundamental parallel between central bank lending and private lending
under lines of credit, and the comparison is illuminating, both for the similarities and the
differences that emerge (Goodfriend and King 1988). The similarity is that both involve
lending large amounts on short notice. They differ, however, in that private credit lines
are explicit contractual commitments, while a central bank’s commitment to lend is a
matter of policy choice. In this section we review the economics of private lines of
credit. Our interest in line-of-credit arrangements is motivated by the question of when a
central bank should lend and when it should not lend. We will be interested, therefore, in
the determinants of the contingencies under which private banks deny credit.

3

1.1. The Line-of-Credit Product
Lines of credit (or loan commitments) specify a maximum amount that can be
borrowed and a formula for determining the interest rate on advances or “take-downs.”
Interest rates are almost universally set as a fixed markup over a reference rate such as
the LIBOR or the lending bank’s prime rate. Borrowers pay an up-front fee when the
line of credit is initiated, as well as an annual “commitment fee” proportional to either the
undrawn portion of the commitment or the entire commitment amount (Crane 1973;
Schockley 1995). Line-of-credit lending is generally secured by collateral, although the
largest and most creditworthy borrowers can obtain unsecured loan commitments. Some
loan commitments provide “backup” support for commercial paper issued by the firm;
the loan is drawn down in the event that maturing paper cannot be rolled over. In this
case the line of credit provides a bank guarantee for the liquidity of the commercial paper
issued by the firm, assuring holders of an orderly exit in adverse circumstances
(Calomiris 1998).
Loan commitment agreements contain covenants that place restrictions on the
borrower’s future financial condition. If the borrower is in violation of one of the
covenants, the lender has the right (though not the obligation) to terminate the agreement
and demand immediate repayment. Some covenants place quantitative restrictions on the
borrower’s financial condition—minimum net worth, minimum working capital, or
maximum leverage ratio, for example. Other types of covenants restrict the disposition
of assets or the issuance of other debt. Loan commitment agreements also generally
contain a “materially adverse change” clause that allows the bank to declare a default in
the event of any “materially adverse change in the financial condition of the borrower.”
This ambiguously worded clause provides a backstop to the other formal covenants,
allowing the lender to terminate lending when the borrower’s financial condition
deteriorates, even if the specific covenants are still technically satisfied. At the same
time, a borrower that is in good financial health can be assured that the bank is still
obligated to lend.
Because the markup does not vary with subsequent changes in the borrower’s
creditworthiness, the line of credit represents an implicit insurance arrangement—a credit
risk derivative. The implicit ex post insurance payout in a given state of the world is the
present value of difference between the contractual markup and the risk premium
appropriate to that borrower in that state of the world. The contract does not provide full
insurance, however, because the bank can limit large payouts by invoking covenants and
denying credit. This partial insurance is valuable to borrowers as a way of smoothing the
cost of contingent funding across various states of the world. Without a line of credit, the
firm would pay a high risk premium if funds were needed when creditworthiness had
deteriorated. With a line of credit, the firm pays ex ante fees and agrees to the possibility
that credit is denied in some states in order to assure ex post access to funds at a lower
risk premium. The ex ante fees compensate the bank for the implicit insurance provided.
Lines of credit tend to be provided by financial intermediaries in general, and
banks in particular. By diversifying over a large number of risks that are to some degree
independent, banks can offer insurance-like products at low cost. Bank loan officers

4

specialize in evaluating creditworthiness and are ideally suited to monitor the borrower’s
condition over the life of the commitment. Such information gathering, built up through
repeated interactions with the borrower, is crucial in evaluating later requests by the
borrower to take down credit. Historically, lending and related credit evaluation
activities often have been combined with issuing demandable liabilities like banknotes or
deposits (Goodfriend 1991; Nakamura 1993). Thus banking institutions have
traditionally dominated the line-of-credit business.
1.2 Agency Problems
The modern approach to understanding the provisions of financial contracts sees
them as the result of ex ante negotiation among contracting parties in the context of
competition from alternative borrowers and lenders. Contractual provisions play a role in
influencing the agency problems that may arise due to asymmetric information during the
course of the contractual relationship. Bargaining is presumed to lead to contractual
arrangements that are efficient in the sense that no other feasible contracts would make
one party better off without making some other party worse off. Competition ensures
that no contracting party is worse off than they would be if contracting with some other
party instead.3
In the context of bank lending to commercial firms, the critical agency problem is
the possibility of managerial moral hazard during the life of the commitment. Many
managerial actions are difficult or impossible to specify as explicit conditions of the
contract, either because they are not easily verifiable by the lender or a court, or because
their complexity makes them too costly to include. Often there are private benefits to the
manager-borrower of continuing to operate the business—“control rents”—which are
impossible to transfer to outsiders. The manager may have significant human capital tied
to the existing organization and operation, the value of which might be lost or diminished
in a closure or liquidation. The manager may enjoy perquisites from controlling the cash
flow of the firm. More fundamentally, inducing the manager to take actions beneficial to
the firm might require giving the manager a pecuniary interest in the profits of the firm.
Borrowers and lenders may in some circumstances have conflicting interests over such
actions. When the net worth of the firm is low, the manager’s interest in the firm has
strongly option-like properties; the manager would reap the upside gain of a recovery in
the business, while the costs of a deterioration would affect mainly the creditors. The
manager can have a distorted incentive to make “all-or-nothing” gambles on excessively
risky prospects.
If left unchecked, the moral hazard problem at a firm will tend to steadily grow
over time. Initial losses erode net worth to the point where risk incentives shift. The firm
begins to seek out investments with large potential payoffs, hoping to gamble their way
back to health. The cost of such investments is below-normal rates of return in the states
in which the large payoffs are not realized. Net worth is most likely to erode further as a
result, exacerbating the moral hazard problem. Each round of losses further strengthens
risk-taking incentives.
3

See Harris and Raviv (1991, 1992) for recent surveys of the financial contracting literature.

5

Moral hazard can involve more than just the borrower. Other creditors will
condition their strategy on the behavior of the firm’s line-of-credit provider. If a lender
pulls a line of credit backing up a commercial paper program in a situation in which the
borrower does not have the funds to roll over maturing claims, the firm defaults and
investors may take a loss. The rate of return on the commercial paper will therefore
reflect market expectations about the future funding behavior of the lender. Overly lax
lending policy will show up as an inappropriately small risk premium on the firm’s
commercial paper or as an overly generous willingness to lend on the part of private
investors. This issue is crucial for firms with illiquid assets that wish to issue liquid
liabilities. A lender with confidence in the solvency of the firm will be willing to lend in
support, while an assessment that the firm is insolvent will likely trigger withdrawal.
At the time the lending contract is negotiated, the contracting parties will
anticipate the possibility of agency problems arising. Financial contracts deal with
agency problems in two ways. First, contractual conditions can explicitly constrain a
manager’s decisions. Such constraints show up in lending agreements as loan covenants,
which we discuss in detail below. Second, a change in control of the firm removes the
manager from a decisionmaking role. Liquidation is a leading example; the firm’s
tangible assets are sold and the proceeds are distributed to creditors. A “reorganization”
supervised by bankruptcy court is another type of control change; management is often
removed, but even when management remains in place, their decisions are sharply
constrained while the firm is under court-sponsored supervision.
Control changes serve three purposes in the context of the agency problems
afflicting lending arrangements. First, removing existing management prevents further
value-wasting actions on their part. Second, separating management from the quasi-rents
associated with controlling the firm acts as a pecuniary punishment that helps provide ex
ante incentives to manage the firm faithfully. Third, control changes facilitate
restructuring the liabilities of the firm, realigning them with changing circumstances and
repaying creditors that wish to terminate their relationship with the firm.
Liquidation will be efficient ex post if it maximizes the total value of the firm.
Inefficient liquidation—selling the firm’s assets for less than the value of the firm as a
going concern—reduces the total expected value of the firm in those states, and thus
reduces the ex ante expected value of the firm. Provisions that reduce the likelihood of
inefficient ex post liquidation will be preferred by both parties ex ante, since the ex post
value of the firm will be larger in those states. On the other hand, managerial control
rents are extinguished when the firm is liquidated. The loss of these rents is a legitimate
social cost of liquidation. Since control rents can only accrue to the managers, lenders
will not take them into account in deciding when to liquidate. The cost of transferring
control rights to lenders is that they will want to liquidate too often—when liquidation
value exceeds the value as an ongoing concern, excluding control rents. Efficient
liquidation rules will balance the benefit of control changes against the cost of inefficient
liquidation (Diamond 1993).

6

1.3. Credible Commitments
The circumstances under which control changes take place are determined by
contractual terms (as well as the implicit background rules embodied in the relevant legal
codes) that determine the assignment of property rights under various contingencies. The
borrower and the lender will have an incentive ex ante to design contractual provisions
that ensure that ex post decisions about liquidation and the allocation of control rights are
efficient, in the sense that they maximize the expected ongoing value of the concern as a
whole (subject to the constraints imposed by informational frictions they face).4 Loan
covenants and collateral provisions play a critical role in structuring the ex ante
incentives to effect control changes under line-of-credit arrangements.
Loan Covenants
Loan covenants play a crucial role in structuring ex post incentives for the lender.
Under the conditions spelled out in the loan covenants, the lender has the right to
withdraw funding. If funding cannot then be obtained elsewhere, as is likely (see
discussion below), the lender can essentially force reorganization or liquidation. Absent
violation of the covenants, the borrower retains control of the firm. Loan covenants thus
can be viewed as conditionally transferring the control of the reorganization/liquidation
decision to the lender. Covenants also control other forms of ex post moral hazard
directly by limiting the manager’s right to take on new risks, change lines of business,
assume new indebtedness, and so on (Aghion and Bolton 1992; Berlin and Mester 1992).
Loan covenants can be quite strong. Taken together, the set of covenants in a
typical loan appears to be quite difficult not to violate. In practice, however, violation of
a loan covenant is merely an occasion for renegotiation between lender and borrower.
The lender can waive the violation or can use the ability to declare (technical) default as
leverage to obtain more favorable monetary terms or more stringent covenant conditions
(a partial control transfer). Renegotiation allows outcomes to vary with ex post
contingencies in ways that would be difficult to provide for ahead of time in the formal
contract (Huberman and Kahn 1988; Kahn and Huberman 1989). Covenant restrictions
can be made strict, in the expectation that in some circumstances they will be waived or
loosened by the lender. Although the borrower and the lender cannot precommit not to
renegotiate, the loan agreement can influence outcomes by having the allocation of
property rights depend on future circumstances.
It makes sense, from an ex ante point of view, for the allocation of bargaining
rights implied by loan covenants to depend on how risky it would be to lend more to the
firm. When covenants are violated, managerial moral hazard is likely to be more
pronounced. If further lending is to take place, it will have to make the lender as well-off
as withdrawing the credit line and forcing reorganization or liquidation, if need be. In
this case the lender is in a position to insist on a higher markup or more collateral to
compensate for the heightened risk of continued lending. If the lender cannot be
4

Not all control changes are instigated by lenders; they can also take place at the initiative of the firm’s
governing board, presumably representing the interests of shareholders.

7

satisfied—if no such terms or collateral exist—then further lending is, presumably, ex
post inefficient or infeasible and the borrower is insolvent. When covenants are fully
satisfied, managerial moral hazard is likely to be muted and so the lender does not have
the ability to prevent further lending. The bargaining power rests with the borrower, who
is quite likely to be solvent in this case. Lending takes place at the borrower’s request at
the pre-agreed rate. The ex post self-interest of lenders, the ability to renegotiate, and the
presence of relatively strict loan covenants provide a contractual mechanism that credibly
commits the lender to limit lending when appropriate.
If given the choice ex post, the lender would never want to extend new lending to
an insolvent firm. A firm is insolvent unless the present discounted value of future cash
flows exceeds the real current value of liabilities. Without a positive gap between future
receipts and future obligations, the present value of anticipated future repayment streams
cannot possibly cover the value of the current loan advance. Lending in such
circumstances would represent subsidization, and a profit-maximizing lender has no
reason to subsidize customers under competitive conditions.5
Collateral
The secured lender’s ability to seize collateral for nonpayment is an important
contractual right. A lien on an asset that is essential to the borrower’s operations can
provide the lender with another means of forcing the borrower’s liquidation. In addition,
collateral reduces the lender’s risk by providing compensation in states when the
borrower cannot pay the obligation in cash, thus allowing a lower risk markup. Collateral
also sharpens the borrower’s incentive to repay, which helps relax borrowing constraints
by allowing larger credible repayment obligations (Lacker 1998). Moreover, in
bankruptcy, secured debt has a priority claim on the pledged assets. Collateral thus
prevents dilution of the lender’s position.
The ability to take new assets as collateral later in the lending relationship helps
overcome the classic underinvestment problem associated with debt overhang (Stulz and
Johnson 1985). When the value of the firm is below the nominal value of outstanding
debt, part of the return to any investment accrues to current debtholders; the real value of
their debt increases. By pledging collateral, the borrower and the new lender can
appropriate and share between them much of the gains from the new investment. Junior
lenders can prohibit financing new projects with secured debt by including a “negative
pledge clause” that prohibits pledging collateral to other lenders. Many junior creditors
do not do so, however, and it is not in their interest if it would prevent some valueenhancing investments. For many publicly issued bonds, the firm retains the right to
finance new projects with secured debt. Note that the presence or absence of a negative
pledge clause for junior debt is a matter of contract. Note also that the lender’s decision
to take additional collateral is subject to ex post rationality constraints; it must be in the
lender’s self-interest to do so.
5

The control rents enjoyed by the manager should, strictly speaking, be counted as part of the total value of
the firm as a going concern, but since (by definition) these cannot be pledged to outsiders, they are
irrelevant to financing decisions.

8

It is important to recognize that collateralized lending is not perfectly safe. The
value that can be realized by seizing and disposing of collateral is uncertain and in some
circumstances can fall short of the nominal obligation it backs. This feature is no
accident, since borrowers have a greater incentive to default and surrender collateral
when its value has fallen below the value of the debt. Why would lenders agree to terms
under which they may take a loss on collateral? As noted above, the key role of
collateralized debt is to enhance the repayment incentive of the borrower. Collateral that
is worth more to the borrower than to the lender, perhaps due to the transactions costs
associated with liquidating the collateral, can provide adequate repayment incentives
even though the lender suffers a loss when the borrower defaults and transfers the
collateral (Lacker 1998). Moreover, collateralization alters ex post bargaining positions
in any renegotiation by the borrower and the lender.
Monitoring
As mentioned above, line-of-credit lending is accompanied by costly informationgathering. Banks assess the borrower’s credit risk prior to the contractual commitment in
order to set contract prices appropriately and to screen out inappropriate risks to which
the lender is unwilling to lend. After the lending commitment has been signed, ongoing
monitoring takes place, partly in the form of periodic financial statements required by
covenant, and partly through informal contacts. Note that any arbitrary informationgathering can, in principle, be negotiated as part of the commitment agreement. For
example, many agreements stipulate that the lender receive audited financial reports. In
other cases, particularly for small firms, the burden of audited statements is judged too
costly and unaudited reports are accepted instead. In negotiating the monitoring features
of the contract, the marginal value of additional information-gathering presumably is
balanced against the expected incremental joint cost.
Lenders have a strong incentive to engage in ongoing information-gathering in
order to be able to assess as accurately as possible the solvency of the borrower. Periodic
monitoring thus helps prepare the lender to make critical decisions when the borrower
experiences financial distress (Rajan and Winton 1995). What is learned about the
characteristics of the firm’s cash flow can help the lender interpret payment problems and
form a more accurate assessment of the value of the firm as a going concern. Such
information will be useful when the lender decides whether to extend or deny credit in
response to covenant violations. In comparison, a lender with no prior lending
relationship with the borrower will be at a distinct informational disadvantage.
Information-gathering gives rise to “relationship lending”—the observation that
ties between lenders and borrowers are typically long-lasting (Berger and Udell 1995;
Petersen and Rajan 1994; Petersen and Rajan 1995; Sharpe 1990). This effect is
particularly acute in times of distress, when outsiders are unable to acquire information
fast enough to assist the firm on the same terms. The informational hurdles facing
alternative lenders make the current lender’s decision to grant or deny credit all the more
crucial. When the informational advantage of a lending relationship enables a firm to
obtain funds at a low enough cost to continue operating, and that same firm would not
have been able to obtain funds cheaply enough without a lending relationship, we can say

9

that the firm is illiquid though solvent. Withdrawing credit in this setting can effectively
force reorganization or liquidation.
Safeguards for the Borrower
From the borrower’s point of view, the important feature of loan covenants is that
they define the limits of the lender’s power to abrogate the agreement and demand
accelerated payment. In the absence of violation of the covenants, the lender is
compelled to lend. As the lending relationship matures over time, the quasi-rents
associated with the lender’s informational advantage over competing lenders will grow.
If the lender had blanket authority to demand repayment, the lender would be tempted to
extort concessions from even a financially healthy borrower. All the quasi-rents from the
relationship would inevitably accrue to the lender. To safeguard the borrower against
such opportunistic behavior, the line-of-credit agreement stipulates that the lender is
compelled to lend at a pre-agreed risk premium, absent any violation of the covenant
conditions.
To summarize then, line-of-credit agreements are crafted to address the moral
hazard problems that are anticipated to arise if the borrower later gets into trouble. In the
presence of loan covenants and collateral provisions, the self-interested profit motive of
lenders allows them to credibly commit to make appropriate decisions to withdraw credit
and induce closure or reorganization. Costly periodic monitoring efforts enhance the
lender’s ability to gauge the borrower’s situation.

2. Central Bank Lending as a Line of Credit
The contractual framework governing line-of-credit lending provides a useful lens
through which to view central bank lending policy. In this section we describe the
similarities and differences between central bank lending and lending under private loan
commitments. Our aim here is to compare central bank lending practices against the
benchmark of private lending mechanisms, without prejudging the usefulness of public
provision of line-of-credit lending.6
2.1. Central Bank Lending
At first glance, central bank lending would appear to be quite different from
private line-of-credit lending. Central banks do not necessarily enter into contractual
arrangements with potential borrowers. Instead, the central bank is given statutory
authority to lend to broad classes of institutions. Central banks are publicly chartered
institutions and, unlike private lenders, profit maximization is not their primary mission.
Despite these apparent differences, central bank lending functions in
fundamentally the same way as a private line of credit—by providing guaranteed access
6

See Goodhart (1988) and Schwartz (1992) for alternative views on the desirability of central bank
lending.

10

to borrowed funds at a predetermined rate. The rate at which central banks lend is
generally posted in advance, rather than negotiated ex post with each individual
borrower. Thus central bank lending rates do not appear to vary much with the
borrower’s ex post creditworthiness. At times, distressed borrowers turn to the central
bank because private alternatives would be exorbitant, either in terms of explicit
financing cost or because they would require surrender of control. Access to central bank
credit therefore appears to provide implicit insurance to those that qualify. One
difference between the pricing of central bank credit and private lines of credit is that
central banks generally do not charge explicit ex ante fees for the service, although one
could argue that the central bank commitment is bundled together with an array of
regulatory burdens (and privileges).7
The classic rationale for central bank lending is to allow illiquid but solvent
institutions to meet their maturing short-term obligations. The extreme case is to fund a
run on demand deposits. Note that this function closely parallels the role of bank lines of
credit in backing up commercial paper programs. The facility is designed to help the firm
cope with an emergency “run”—an inability to roll over the credits. As noted above, a
decision to withdraw credit can trigger default on the commercial paper and closure or
reorganization of the firm. Conversely, lending can stave off collapse. In the case of a
bank run, central bank lending decisions are often critical to keeping an institution afloat.
In many situations, the only alternative to a central bank loan is closure. But note the
mechanism that links credit withdrawal and closure in each case. A private lender denies
credit, causing a default, which leads creditors to seek remedies by seizing assets. The
borrower files for bankruptcy to obtain protection from creditors while a division of the
losses can be negotiated. A central bank that denies credit to a bank forces the hand of
the chartering agency or the deposit insurance fund. The central bank’s critical role in
bank closure brings it face-to-face with the government agencies that have direct
responsibility for closing banks.
2.2. Agency Problems
Another similarity between central bank lending and private line-of-credit lending
is the importance of borrower moral hazard. A vast array of bank management decisions
involve risk-return trade-offs. At any leveraged entity attitudes toward risk are to some
degree distorted, because some decisions affect the value of debtholders’ claims. Banks
are among the most highly leveraged of institutions. At well-capitalized banks, the value
of future quasi-rents owing to banks’ special regulatory privileges acts as an implicit
performance bond that offsets risk-taking incentives. When net worth falls, however, the
value of the implicit bond vanishes and incentives flip toward risk-taking—little is left to
lose. It is now widely recognized that the management of a poorly capitalized bank has
incentives to take on excessive risks to attempt to gamble their way out of trouble. When
supervisory restraint is lax—as during the U.S. savings and loan crisis or in the recent
emerging-markets banking crises—moral hazard steadily grows as the losses pile up
(Calomiris 1998).
7

See Kwast and Passmore (1997) for evidence on the net subsidy provided by the financial safety net in the
United States.

11

Private banks make explicit case-by-case decisions to grant lines of credit. In
contrast, central bank lending commitments are not usually made on an individual basis
ex post. Often there are legislative and regulatory policies delimiting the set of
institutions that have access to central bank credit, but sometimes the set of institutions
with access is quite large.8 The key difference here is that private institutions are able to
condition the commitment on an examination of the prospective borrower’s financial
health and then tailor the contractual terms to the individual borrower, while access to
central bank credit is granted to broad categories of institutions. Also, the terms of
central bank lending do not reflect the competitive discipline of arm’s-length bargaining.
Central bank supervision of institutions with access to central bank credit is a
direct counterpart to the ongoing monitoring performed by banks. For central banks
without a direct supervisory role, access to supervisory information performs the same
function; keeping the prospective lender apprised of changes in the creditworthiness of
the borrower. Supervisory information is generally far more detailed than the reporting
required of private line-of-credit customers. As noted earlier, private contracts can, in
principle, mandate stricter disclosure, but there are impediments to doing so. In the
United States, provisions of bankruptcy law discourage lenders from becoming so
intimate with the management of the firm as to be deemed an “insider” (Baird 1993).
Like private line-of-credit lending, central bank lending is generally
collateralized. Specific assets can be documented and evaluated in advance, drawing on
the central bank’s supervisory knowledge. In addition, central banks’ security interests
are generally favored in bank failure resolutions. This tends to make central bank lending
relatively safe, although, as noted above, collateralized lending is not risk-free in general.
In lending to government-insured institutions, collateral plays a crucial role in the
effect of the loan on the insurance fund in the event of a failure. Collateralized lending
dilutes junior claimants, which in the case of an insured bank includes depositors. The
insurance fund stands in for the depositors in the event of closure, however, so central
bank lending effectively dilutes the deposit insurance fund. For example, in the United
States, the FDIC assumes the failed bank’s indebtedness to the Federal Reserve, and in
exchange retains the pledged assets. When the Fed lends to allow a failing bank to pay
maturing short-term obligations, the insurance fund retains the collateral assets, but the
maturing short-term obligations have been replaced by a fixed obligation to the Fed. If
the released short-term claimants were insured depositors, the operation has merely
replaced one fixed obligation for another. If some short-term claimants were uninsured,
however, things are different. The short-term claimants would have been junior to the
FDIC’s claim on behalf of the insured depositors. The insurance fund inherits a bank in
which an uninsured junior claim held by the private sector has been replaced by a fixed
senior claim held by the Federal Reserve. On the other hand, closure has been delayed
and private uninsured creditors have been spared.
8

In the United States, for example, all depository institutions that are subject to reserve requirements are
eligible to borrow at the Federal Reserve’s discount window. In addition, section 13 of the Federal Reserve
Act allows the Board of Governors “in unusual and exigent circumstances” to authorize the Reserve Banks
to extend credit to any individual, partnership, or corporation, provided the Reserve Bank obtains evidence
that such entity “is unable to secure adequate credit accommodations from other banking institutions.”

12

2.3. The Commitment Problem
As with private lines of credit, the critical property of central bank lending is the
nature of the circumstances in which it does and does not take place. With private lines
of credit, lender profit maximization provides ample incentive to advance credit when it
is ex post efficient to do so. The environment surrounding central bank lending is in
some respects quite different, but it also provides incentives to extend credit when it is
desirable to do so. Although their formal organizational structure parallels private
banking institutions, central banks do not attempt to maximize accounting earnings.
Instead, they operate under legislative policy oversight and mandates that charge the
central bank with responsibility for “the stability of the financial system.” A decision not
to lend that is followed by market turmoil creates immediate risks. Most importantly, the
central bank could be blamed for the negative consequences for the economy of its
refusal to lend. Moreover, a central bank that precipitates the demise of one or more
financial institutions may be subject to direct action through the legal system or indirect
action through the legislature. Since one of the main responsibilities of a central bank is
to protect the financial system, central bank officials might be inclined to interpret a risk
to the financial system in a way favorable to lending. Equally important, it is impossible
to prove the counterfactual, i.e., that not lending and letting a troubled firm fail in a
particular case would not have seriously disrupted markets. It is very difficult for
outsiders to question a central bank’s judgment on such matters after the fact.
Even apart from a financial stability mandate, the unique ability of central banks
to finance lending by creating high-powered money makes them an irresistible target of
forces seeking an off-budget rescue of a troubled but influential institution. The
chartering authority may want to delay the immediate budgetary consequences of an
institution’s failure, perhaps with the concurrence of the legislature. The chartering
agency or the legislature might pressure the central bank to lend to insolvent institutions
in order to postpone closure and prevent losses to creditors (Kane 1989). As we noted
above, collateralized central bank lending to delay closure effectively allows uninsured
short-term creditors of the troubled institution to escape unscathed. Moreover,
widespread perception of a central bank commitment to aid (large) institutions whose
demise could threaten financial stability might necessitate a commensurate commitment
to smaller institutions on equity grounds. For both reasons then—safeguarding financial
stability and assisting insured institutions’ chartering authorities—central banks have an
ample incentive to lend when warranted.
For private providers of lines of credit the prospect of losses, or, more generally,
lending at a rate below the appropriate risk-adjusted rate, provides a self-interested
motive to deny credit and force closure or reorganization when the borrower is in poor
enough condition. Loan covenants give them the ability to do so. Are there
countervailing incentives for central banks that would lead them to withhold lending in
some circumstances? As noted above, there are usually strong pressures to lend. Is there
an institutional mechanism to allow central banks to credibly commit to resist these
pressures and withhold lending from insolvent institutions?

13

Although central banks are not formally responsible for maximizing portfolio
earnings, they would seem to have strong incentive to avoid subsidized lending. Lending
that appears not to have been necessary to protect the financial system, and that appears
to have saved equity interests, has the appearance of cronyism. What’s worse, a central
bank could actually lose taxpayer money. In either case, there could be immediate
legislative repercussions. As a result, some central banks lend only on terms that
virtually guarantee repayment in full (Hackley 1973). In the United States, for example,
discount window loans are virtually always collateralized, assuring priority in closure.
Moreover, the FDIC generally assumes the borrowing bank’s indebtedness to the Fed in
exchange for the collateral, relieving the Fed of the risk of falling collateral value. This
arrangement allows the Reserve Banks to avoid lending losses but has the effect of
shifting those losses to the deposit insurance agency.
Implicitly restricting central bank lending to be risk-free in this sense is a “bright
line” policy that is easy to verify ex post. Such a policy is one way to limit central bank
involvement in credit allocation and restrict the scope for subsidization. Limiting central
bank involvement in credit allocation can help buttress the central bank’s independence
and bolster the fiscal discipline of the deposit insurance fund (Goodfriend 1994). One
might think that a bright-line no-loss policy would sharpen the central bank’s incentives,
bringing them more closely into line with those of a private line-of-credit provider. Full
collateralization is one such no-loss policy. By itself, however, this policy is not enough.
Because the deposit insurance fund has the ability to make the central bank whole by
assuming the insured institution’s indebtedness, the central bank has no pecuniary reason
to object and thus is even more vulnerable to pressure to delay closure by lending.
Central bank lending facilitates rollover of short-maturity bank liabilities, much
the way line-of-credit lending facilitates rollover of commercial paper. As with private
backup lending, inappropriate liquidation policy can give rise to moral hazard in the issue
of liquid liabilities. Anticipation of such central bank lending by private lenders creates a
potentially severe moral hazard problem; markets would expect the central bank to
provide the bank with the funds to allow the exit of liquid claimholders. Again, this
strongly resembles the role of back-up lines of credit for commercial paper issuers in
providing emergency access to liquid funds to allow firms to service maturing short-term
debt. The distinction is that central bank lending facilitates a reallocation of wealth
among failing bank creditors that the deposit insurance fund has neither the capability nor
the legal authority to perform by itself. Unlike private lending, in which the bailout must
be ex post rational for the lender, the central bank is not subject to the same profitmaximizing discipline. Moreover, private lending to a failing firm is subject to the
safeguards of bankruptcy law, including the fraudulent conveyance provision, which
under certain conditions allows the court to unwind transactions that occurred
immediately prior to bankruptcy if they disadvantaged the bankrupt firm’s estate. Central
bank lending accompanied by indemnification from the deposit insurance fund is subject

14

to no such discipline, only the vagaries of the political system’s response, which, as noted
above, is likely to be tilted toward leniency.9
The financial stability mandate of the typical central bank can create pressure to
expand the scope of central bank lending to nonbank financial institutions, for central
banks whose formal authority allows it. A wide array of nonbank financial
intermediaries are capable of amassing positions the liquidation of which could be seen
as a threat to the stability of asset prices and the solvency of many other financial
institutions, including insured banks. Moreover, short-term credit linkages between the
failing nonbank intermediary and other financial market participants widen the interest in
central bank liquidity assistance. A central bank with no formal authority to lend outside
a narrowly defined set of institutions is, of course, well positioned to resist influence.
Otherwise, we might see a tendency to extend the range of borrowing institutions.10
We are forced to conclude that the institutional incentives for a central bank to
limit lending are relatively weak. As a result, we should expect to see a general tendency
for central banks to overextend lending, with the anticipated consequence of exacerbating
moral hazard problems among institutions deemed likely to qualify for central bank
credit. Moreover, the rate of incidence of financial distress that calls for central bank
lending should show a tendency to increase over time, as market participants come to
understand the range of the central bank’s actual (implicit) commitment to lend and
adjust expectations accordingly.

3. Coping with the Commitment Problem
To summarize the argument so far, we saw above how private banks could
efficiently and profitably structure contracts to support private lines of credit. They do so
because (1) their own money is at stake, (2) they can choose their borrower relationships,
(3) the conditions involve the right to monitor the value of assets on an ex ante (ongoing)
basis to distinguish illiquid from insolvent borrowers in the event of a request for funds
(4) loan covenants give the lender the right to easily withdraw credit when the borrower’s
financial condition has deteriorated, and (5) competition and profit maximization induce
private providers to balance the risks of accommodating a request for funds against the
costs of not lending. To be competitive, a line-of-credit product could not exploit
borrowers; and to be profitable, a credit line would have to provide a risk-adjusted return
comparable to other products offered by banks.
Central bank line-of-credit provision is undertaken under such different
circumstances that we can’t presume lending decisions will be made appropriately. First,
financial losses are not borne by the central bank but by the Treasury and, ultimately,
taxpayers. Second, a central bank cannot offer take-it-or-leave-it conditions because it is
responsible for protecting financial markets as a whole and may not be able to refuse to
9

For an account of Federal Reserve lending to depository institutions, see An Analysis of Federal Reserve
Discount Window Loans to Failed Institutions (1991).
10
For an account of Federal Reserve lending to nonbanks, see Garcia (1990).

15

lend to an institution whose failure might threaten the system. Third, for the above
reason, a central bank might feel pressure to lend to an institution that it doesn’t examine
thoroughly, or at all. Fourth, a central bank is not disciplined by competition or profit
maximization.
At any point in time, then, a central bank will be more inclined to lend than not
whenever not lending could threaten the entire financial system. Such incentives assure
that the central bank carries out its legislative mandate to stabilize financial markets. The
problem with such an inclination is that it creates in the public’s mind an expectation that
if a financial institution is in a protected class, then it can count on credit assistance from
the central bank in certain adverse circumstances that could arise in the future. Private
lenders will take advantage of central bank assistance by accepting greater credit risks
when lending to implicitly protected firms. And borrowing firms in the protected class
will take advantage, too, by taking on increasingly risky assets. Over time, the central
bank will be inclined to expand the class of firms perceived to be protected and the extent
of protection.
The fundamental problem for central bank lending is to find a way to credibly
commit to limit lending reach. It is a difficult problem and there are no easy solutions.
In what follows we consider the practical effectiveness of five broad approaches to the
commitment problem.
3.1 Good Offices Only
In lieu of establishing a practical means of committing a central bank not to lend
except in deserving circumstances, we could imagine legislation precluding a central
bank from extending its own credit under any circumstances. This possibility is worth
considering because a central bank could still play a useful and effective role in
facilitating private credit transactions, or those of other national or international agencies.
A central bank has three institutional strengths in this regard. First, its financial
independence and independence from the budget process give it an impartiality with
respect to financial matters difficult to find anywhere else in the government or, for that
matter, in the private sector. Second, a central bank has a large staff with practical
experience in economics, supervision and regulation, payments system operations, and
financial law. Third, in the course of carrying out their normal duties, high central bank
officials develop personal relationships with their counterparts in the private sector.
Thus, a central bank could offer its “good offices” to help private creditors
negotiate a recapitalization of a troubled financial firm. The central bank might have
better knowledge of the troubled firm through existing supervisory relationships. The
central bank might be in a position to “certify” the solvency of the firm to others,
essentially facilitating “due diligence” efforts. Even in the absence of ex ante central
bank knowledge of the institution, the central bank might inspect the portfolio for others,
acting as a trusted third party. In negotiations among members of a potential lending
consortium, the central bank might play the role of neutral arbitrator.

16

In principle, the extension of good offices needn’t involve pressures or sweeteners
from the central bank. In practice, however, as long as a central bank retained
supervisory and regulatory powers one could not be sure whether private parties to the
agreement were influenced implicitly by a concern about some punishment should they
not sign on to the deal. In effect, then, a deal could have been facilitated by implicitly
directed credit allocation because of the central bank’s involvement. And if the central
bank could still lend, then a deal might be implicitly sweetened if the parties believed that
the central bank would be more inclined to lend to the troubled firm in the future. Parties
could also believe that regulatory authorities, including the central bank, would forbear if
the institutions that lent became troubled themselves. Of course, a deal could very well
involve a considerable transfer of equity from the original owners to the new owners.
But if a central bank presides over a deal more favorable to the original owners than they
would have gotten without its help, moral hazard has increased.
One way to be sure that no implicit pressures or sweeteners are involved when a
central bank lends its good offices would be to take the central bank out of both
supervision and regulation, and lending. But then the central bank would lose the
professional and personal connections that make it a good facilitator in the first place.
The upshot is that even limiting a central bank’s role to one of facilitator tends to create
in the public’s mind the possibility of future credit assistance of one kind or another.
3.2 Lending Hurdles
Recognizing that there are circumstances when central bank lending would be
desirable in order to protect the financial system, we consider various hurdles designed to
limit the central bank’s inclination to lend except in extreme circumstances and to limit
the central bank’s exposure if it does lend. We take up these in reverse order. First, we
consider the taking of collateral. After that, we consider the effectiveness of hurdles that
a central bank might be made to clear before it is authorized to lend in the first place.
Collateral
Some central banks have chosen to lend only on good collateral to fully protect
their funds in the event that the borrower cannot repay. The taking of good collateral
certainly protects the financial integrity of central bank lenders themselves. And it might
appear to limit the exposure of taxpayers, but this is not the case. Allowing a central
bank to take good collateral to back its loans permits borrowers to more cheaply obtain
funds to continue operating. Moreover, central banks might be inclined to lend as long as
good collateral is forthcoming. Consider what this would mean for a bank with insured
and uninsured deposits. As word of a bank’s possible insolvency got around, uninsured
depositors and other uninsured lenders, e.g., interbank loans, would withdraw their funds
first. By helping to pay out uninsured creditors, central bank loans help uninsured
creditors get their money out of the troubled bank before it is declared insolvent and
closed.
Its lending well protected, a central bank would have little incentive to precipitate
a borrower’s insolvency by refusing to lend. A central bank supervising a borrowing

17

bank might be in a good position to evaluate even the illiquid portions of a portfolio for
purposes of collateral and could keep a bank operating for some time. In effect, such
central bank lending tends to provide uninsured creditors of a troubled bank with free
insurance and to delay the time when a troubled bank would default to one of its creditors
and trigger its closing and reorganization. Assets that could have remained in the bank,
if it had been closed sooner, are now pledged to the central bank and are unavailable to
help the deposit insurance fund and the taxpayers pay off insured deposits.
In short, fully collateralized central bank lending hides the fact that the central
bank is responsible for exposing the insurance fund or the taxpayer to a risk of loss.
Moreover, fully protecting the central bank actually increases its inclination to lend.
Early Intervention
One option to better protect the deposit insurance fund and the taxpayer is to
require bank regulators to close a failing bank when its book-value equity capital falls to,
say, 2 percent rather than at the point of book insolvency. A deterioration of book capital
could trigger progressively heavier regulatory restrictions. Such a restriction might
prohibit additional central bank lending at some point, unless written permission to lend
is given by the highest officials in the government.
The problem with this hurdle is that it is based on book- rather than market-value
capital. For depository institutions whose assets are in large part illiquid nontraded loans,
a bank could become insolvent on a market-value basis well before it is declared
insolvent on a book-value basis. For example, consider the Bank of New England, which
was declared insolvent in January 1991. The following day, the FDIC estimated that the
deposit insurance claim would cost the taxpayer around $2 billion. Why didn’t the
regulators act sooner?
The Bank of New England’s problems began when the mortgage loans it made in
the mid-1980s turned bad. Real estate proved unable to earn a sufficient return to cover
the loan payments. The bank, however, still had to pay the competitive interest rate on
deposits. Even though the deposits were fully insured, depositors required the same rate
of return they could get elsewhere. So the bank had to divert to depositors a portion of
the return on assets that had been going to equity holders. The cut in dividends caused
the stock price to fall precipitously. In the event, the bank could not meet the competitive
deposit rate payments by reducing dividends alone. The bank had to sell off securities,
pledge assets to the Federal Reserve’s discount window, and attract U.S. Treasury
deposits to fund withdrawals of uninsured deposits and interest payments to the
remaining depositors. The negative cash flow reduced the book-value net worth
gradually until it fell far enough for regulators to seize the bank.
In this case it may be said that regulators were too slow in writing down the value
of loans. It is well to remember, however, that there are often good reasons to be
cautious. The market value of a loan is the present discounted values of future cash
flows. Although current cash flows may be small, tomorrow is another day. Thus, any
write down by a regulator is subjective and liable to challenge ex post by high

18

government officials or the bank in question itself. In other words, examiners cannot be
expected to be responsible for tough decisions any more than high government officials
themselves. Thus, hurdles based on measured capital deficiencies designed to protect the
deposit insurance fund and the taxpayer against losses due to excessive central bank
lending should not be expected to work very well in practice; they merely shift formal
responsibility for an inherently difficult decision.
3.3 Constructive Ambiguity
The above argument suggests that simple mechanistic hurdles cannot be counted
on to limit a central bank’s inclination to lend. The problem is that financial markets
know that there are circumstances when a central bank would not refuse to lend to
troubled institutions because of the possibility of systemic effects. Thus, owners of
institutions that are big enough or central enough to the payments system or to financial
markets more generally have an incentive to increase their risk exposure in just those
circumstances. Owners know that they keep the upside returns if things go well but share
any losses more broadly, i.e., with the central bank, an insurance fund, or the taxpayer, if
things go badly.
This sort of logic puts a central bank in a box. A central banker’s willingness to
support the financial system in times of potential crisis (to maintain the confidence
necessary to facilitate the functioning of financial markets and the economy more
broadly) actually causes risks in the system to grow. For this reason, a central bank
might be inclined to keep markets guessing about the exact circumstances in which it
would be willing to lend. By creating uncertainty in the minds of potential borrowers,
such ambiguity might be thought to be constructive because it causes potential borrowers
to take on less risk. Constructive ambiguity, under this interpretation, attempts to reduce
market participants’ perception of the probability of central bank lending while reserving
the central bank’s option to lend when systemic concerns seem to warrant.
Some ambiguity is unavoidable in any attempt to state the precise contingencies
in which a central bank might lend. The true policy would depend on information
available to the central bank at a future date, some of which might be private information
about specific firms known only to the central bank. A policy that needs to be based on
private unpublishable information would not be verifiable and so could not be made
completely free of uncertainty and ambiguity. Moreover, lending policies that depend on
future circumstances in complicated ways might be hard to state with clarity in advance.
That said, one might ask whether a central bank might want to deliberately
increase the uncertainty surrounding its lending intentions. At one level, ambiguity can
be enhanced by not attempting to sharpen or clarify the broad principles of central bank
lending in internal discussions or external speeches of high central bank officials. Over
time, however, markets will learn the central bank’s actual lending policy. If the central
bank does not follow through with actions that ratify the announced ambiguity, its
rhetoric will ultimately come to be disregarded. Market expectations will converge on
the central bank’s actual policy. To be sustainable, therefore, a policy of constructive
ambiguity has to be demonstrated in a central bank’s lending actions themselves.

19

In order to increase ambiguity, a central bank would have to add extraneous
variability to its lending policy—it would have to play a “mixed strategy” in gametheoretic terms. It is as if a central bank would have to couple each lending decision with
a spin of a roulette wheel that would randomly point to “follow through” or “not follow
through.” The central bank would have to be willing to abide by the wheel. That is, with
some positive probability the central bank would lend when its better judgment said the
situation didn’t call for it; and with some positive probability the central bank would have
to follow the wheel and not lend when it would otherwise wish to do so.
Randomization can be economically useful. For example, tax authorities audit
randomly, with audit probabilities that vary with some basic features of the return.
Randomization balances the beneficial incentive effects on taxpayer behavior against the
expected resource cost of the audits. Tax authorities are able to implement mixed
strategies credibly because they have learned over time that failing to audit eventually
leads to increased tax evasion.
The problem with adding variability to central bank lending policy is that the
central bank would have trouble sticking to it, for the same reason that central banks tend
to overextend lending to begin with. An announced policy of constructive ambiguity does
nothing to alter the ex post incentives that cause the central banks to lend in the first
place. In any particular instance the central bank would want to ignore the spin of the
wheel. Supporting a policy of random but limited central bank lending would require
withholding credit with some positive probability in instances in which it is costly to the
central bank. Deliberate enhancement of ambiguity beyond that inherent in lending
policy does nothing to make this choice easier.
A policy of constructive ambiguity in the absence of an ability to precommit runs
the risk of drifting in an expansive direction. The greater the perceived probability of the
central bank lending in various circumstances, the greater the risk-taking incentive for
eligible institutions. Whenever the central bank is seen to lend in a situation in which it
had not lent before, perceived probabilities will be revised upward, inducing greater risktaking.11 This increases the likelihood of circumstances in which the ambiguous policy
would have recommended a positive probability of lending. When the central bank
actually does lend, probabilities are revised upward yet again. A self-reinforcing
dynamic could emerge in which central bank lending encourages risk-taking that makes
future lending even more likely.
3.4 Extended Supervisory and Regulatory Reach
Knowing that it cannot credibly commit not to lend to insolvent institutions, a
central bank could consider extending its supervisory and regulatory authority, or the
11

Note that for the tax authority, the fraction of returns that are audited is published and may have far more
impact on perceived audit probabilities than an individual audit. In contrast, because the frequency of
central bank lending is much lower, individual instances have a far greater effect on market expectations of
future lending.

20

authority of other government agencies, to all institutions that it might possibly wish to
lend to. In principle, such authority would enable the central bank to limit risk-taking
directly. A central bank might want to be sure to extend its regulatory authority to
financial institutions big enough or central enough to threaten the financial system if they
failed. It might be especially interested in preventing insured institutions such as banks
from taking on excessive risks.
There are many problems with attempting to control risks by extending regulatory
authority. First, regulatory reach does not extend across international borders. An
attempt to regulate financial firms too heavily may cause them to locate in those countries
willing to impose little regulation in order to attract the business. Second, an attempt to
extend regulation to firms within a country causes new institutional forms to develop to
escape regulation. Third, the proliferation of new financial instruments associated with
derivatives enables institutions to synthesize financial positions in many ways.
Sophisticated financial engineering has made circumventing regulatory restrictions much
easier. It has become very difficult for regulators to monitor and regulate transactions,
i.e., balance sheet and off-balance-sheet positions within a given firm. This development
is the motivation behind the movement away from direct supervision of balance sheet
items toward a supervisory philosophy focused on institutions’ risk management and
control processes.
The extension of supervisory and regulatory authority to a broader array of
financial institutions risks feeding back on central bank lending policy. Supervisory
involvement in a financial sector can “taint” government authorities with implicit
responsibility for the health of institutions in that sector, heightening the perception that
the central bank is willing to lend to them in the event of liquidity problems. A central
bank might find it costly to disappoint such expectations. Extending the breadth of
supervision and regulation could induce a commensurate extension of the implicit central
bank lending commitment.
In short, it is probably fair to say that while supervision and regulation has its
place as part of a line-of-credit package, it is oversold as a means of controlling risk
taking on the part of owners of firms who could potentially benefit from access to central
bank lending on favorable terms.
3.5 Reputation Building
In our view, none of the above institutional mechanisms can credibly commit a
central bank not to overextend its lending reach, or prevent increased risk-taking
engendered by a central bank’s inability to limit its lending commitment. It remains to
consider whether a central bank could credibly commit to limit its lending by simply
building a reputation for doing so. Given the pressures to overextend its lending
discussed at length above, there might seem to be little hope that a central bank could
ever build a reputation for not lending. It is hard even to begin to think about how a
central bank would start to do so. Yet, we think that the experience by which central
banks around the world have built a reputation for maintaining low inflation provides a
road map for how a central bank might credibly commit to limit its lending.

21

Building A Reputation for Low Inflation12
At first, the inflation that accompanied stimulative monetary policy was tolerated
in the United States as a necessary evil because it seemed consistent with a stable Phillips
curve trade-off in the 1960s. In retrospect, however, we see that deliberately
expansionary monetary policy came to be anticipated by workers and firms. Workers
learned to take advantage of tight labor markets to make higher wage demands, and firms
took advantage of tight product markets to pass along higher costs in higher prices.
Increasingly aggressive wage and price behavior tended to neutralize the favorable
employment effects of expansionary monetary policy. And the Federal Reserve became
evermore expansionary in pursuit of low unemployment.
Disaffection with inflationary policy arose as the Phillips curve correlation broke
down and both inflation and unemployment moved higher in the 1970s. Already in the
late 1960s the Fed began from time to time to try to brake the acceleration of inflation
with tight monetary policy, well aware that such policy actions caused unemployment to
rise. The resulting stop/go monetary policy that characterized the period from the mid’60s until the great disinflation of the early 1980s reversed the rise in inflation and
introduced a period when the Federal Reserve began gradually to acquire credibility for
low inflation.
Two developments paved the way for the great disinflation. First was the
progress that economists made in understanding the causes and cure for inflation. A
professional understanding was critical in giving the Federal Reserve the confidence that
monetary policy could bring inflation down with some short-run cost but great potential
benefit in the long run. Second, two decades of nonmonetary approaches to controlling
inflation—for example, wage/price guidelines and controls, fiscal budget policy, and
credit controls—had been tried and failed.
By the time that Paul Volcker became Federal Reserve Chairman in 1979,
inflationary policy was widely recognized to have costs with no offsetting benefits. But
it was recognized that bringing it down would be costly too. Previous experience with
stop/go policy made that clear. Indeed, the inflation was not broken until a sustained
tightening of monetary policy beginning in 1981 created a serious recession that tested
the Federal Reserve’s determination and the public’s support. With widespread public
support, the Federal Reserve has maintained low inflation for over a decade now.
Macroeconomic performance has been good compared to the inflationary period, and
there has been only one mild recession thusfar, in 1990-91.
Building a Reputation for Limited Lending
Reasoning by analogy to the acquisition of credibility for low inflation, the road
map for how a central bank could acquire a reputation for not lending might be as
follows. The process would begin in a situation where the central bank and the public
alike recognize only the short-term benefits of central bank lending. Central banks would
12

This account is drawn from Goodfriend (1997).

22

be inclined to extend emergency credit assistance to any institution whose possible failure
could present even the remotest risk of disruption to the financial system. A liberal
lending policy would encourage potential beneficiary firms to take on more risks. This,
in turn, would create more frequent crises and cause a central bank to extend its lending
reach ever further. Policymakers and the public would see the frequency and magnitude
of financial crises grow even as the central bank’s willingness to lend increased.
Gradually, under this scenario, a sense would develop that excessively liberal
central bank lending was counterproductive. This view would be supported by progress
among economists in understanding the cause and cure for the increasing risk in the
financial system and its relation to excessive central bank lending. As central bankers
came to feel overextended, they would be more inclined to incur the risk of short-run
disruptions in financial markets by disappointing expectations and not lending as freely
as before. A series of attempts to move in the direction of more restrictive lending
practices might be unable to reverse market expectations that the policy would revert to
more liberal practices. Eventually, the public would decide that the increased financial
crises were due, in part, to excessively liberal central bank lending. And the public
would want the central bank to become more restrictive, even at the cost of precipitating
a financial disruption by refusing to lend in a particular crisis. Ultimately, with the
public’s support and a consistent willingness to risk the consequences, a central bank
would acquire a reputation for more limited lending. Financial firms might then take on
less risk, and financial market crises might become less common.
There appears to be no feasible path toward a credible commitment to curtail
central bank lending that does entail acquiring broad-based public and legislative support.
Limiting central bank lending would restrict the ability of depository institution
chartering authorities to sustain insolvent institutions on life support, requiring earlier
closure and recognition of losses. As the U.S. savings and loan episode demonstrated,
such a strict closure policy would require legislative endorsement in the form of
appropriations sufficient to fund the insurance fund’s actual current obligations.
One might wonder where we are in this process today? It was only in the mid1980s during the saving and loan crisis in the United States that economists and the
public became aware of the greater risk-taking engendered by the government financial
safety net, e.g., deposit insurance and central bank lending. It took almost twenty years
from the first recognition that inflationary monetary policy was unproductive until the
Federal Reserve succeeded in bringing it down permanently. And between the mid-’60s
and the early 1980s there were four major episodes (1966, 1968, 1973-74, 1979-82) in
which the Federal Reserve tightened monetary policy to restrain inflation, with adverse
consequences for employment. To date, there are no instances in which a financial crises
has followed a refusal by the Federal Reserve to extend emergency credit assistance.
And the Federal Reserve has made emergency credit available on numerous occasions in
the last two decades. One might regard the Bank of England’s handling of the Barings
closure as an instance of a move toward a more restrictive lending policy, however. We
think it is fair to say that we are still at the beginning of any path that might eventually
reverse the tendency for the safety net to create moral hazard.

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5. Conclusion
We have presented some guiding principles for central bank lending. Central
bank lending should be regarded as a line of credit and should be expected to exhibit the
tensions inherent in private line-of-credit products. The most serious problem is
managerial moral hazard, the borrower’s incentive to take on more risk after arranging a
credit line. We discussed in some detail contractual provisions (loan covenants,
collateral, and monitoring) designed to control moral hazard. The key point is that
contractual provisions enable profit-maximizing lenders to credibly commit to withdraw
credit and induce the closure or reorganization of a borrowing firm when appropriate.
The contractual mechanisms utilized by private line-of-credit providers are not
effective for a central bank whose primary mission—to maintain financial system
stability—can override its obligation to protect public funds and undercut its ability to
limit its lending reach. We considered in some detail five broad approaches to a central
bank’s commitment problem: good offices only, taking of collateral and early
intervention, constructive ambiguity, extending supervisory and regulatory reach, and
reputation building. Our analysis suggested that the first four institutional approaches
cannot be counted on to overcome the fundamental forces causing a central bank to lend.
On the other hand, we believe that it should be possible for a central bank to build
a reputation for limiting its lending commitment, just as central banks around the world
acquired credibility for low inflation. In fact, we imagine forces operating on central
bank lending policy analogous to those influencing the path of inflation. A period in
which liberal lending policy raises expectations of lending is followed by more frequent
lending, increased moral hazard, and greater financial instability. Gradually,
policymakers and the public become willing to disappoint lending expectations. The
economy then experiences a temporary period of heightened financial instability
associated with increasingly restrictive lending that is followed by less financial
instability and little central bank lending.
We are agnostic about the ultimate role for central bank lending in a welfaremaximizing steady state. We put off the consideration of that difficult question just as
the debate on the desirability of zero vs. 2 percent inflation in the steady state was
deferred until inflation was brought down sufficiently. The critical current policy
question is how to reverse what we regard as the perception that central banks are
increasingly willing to lend, which increases risk-taking and the likelihood that central
banks feel compelled to lend. Just as monetary policymakers looked for opportunities to
disinflate, we think that financial economists and central bankers should begin to think
about opportunities to cut back on central bank lending.

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