RDP 2001-07: A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia 1. Introduction

Last-resort lending can be defined as the discretionary provision of liquidity to individual financial institutions (or to the market as a whole) by the central bank to overcome a shortfall in liquidity caused by a withdrawal of funds from those institutions because of doubts about their financial standing.^[1] While the theoretical literature focuses most on direct lending, Australia's history shows that there are a number of other ways that public authorities have supported financial system stability, including the issuance of statements assuring the public of the soundness of troubled banks, and declaring bank-issued securities to be legal tender. This paper surveys the history of last-resort lending and the provision of other forms of support in Australia, and compares the practical implementation of lender-of-last-resort policy with policy prescriptions from the theoretical literature.

While the Australian banking crisis of the 1890s was among the most severe anywhere in the world during the nineteenth century, since then the Australian banking system has shown itself to be remarkably stable. The twentieth century saw just three Australian banks suspend payment. Direct loans from the central bank have only been provided twice: once as a last-resort loan and once to smooth the exit of a failed bank. In addition, indirect last-resort lending, where the central bank lent to private banks that were lending to non-bank financial institutions experiencing depositor runs, was provided three times during the 1970s. With the exception of depositors at one small bank, who lost just 1 per cent of the value of their deposits, no Australian bank depositor has lost money since 1900. Boom and bust during the nineteenth century, however, resulted in two waves of banking failures – in the 1840s and 1890s – and isolated failures at other times. In these episodes, some depositors incurred outright losses or had their deposits converted into claims on the banks that could not be readily withdrawn (in some instances, full repayment of such claims took more than twenty years). The central bank (the Reserve Bank and its predecessor, the Commonwealth Bank) has been the source of last-resort support since early in the twentieth century. However, prior to its establishment, both the banking industry association and colonial governments provided last-resort support to troubled banks in the nineteenth century.^[2] The resource constraints faced by these institutions have been important in determining the type of last-resort support provided, in particular whether a direct loan was made or the liquidity support came in some other form.

Lender-of-last-resort policy aims to counter the potential for market failure to cause solvent banks to fail due to liquidity constraints. In some instances, it may also seek to insulate the economy from the systemic effects of bank failure. By providing such protection, however, the lender of last resort risks undermining market discipline of banks' risk-taking. Theoretical analysis of lender-of-last-resort policy focuses on how support can be provided in ways that maintain incentives for banks to prudently manage their risk-taking. In Australia, the methods used to maintain such discipline have included specific caveats on last-resort loans, lending only against high-quality collateral and allowing insolvent institutions to fail.

Footnotes

Last-resort lending involves ‘the provision of liquidity support in circumstances where either the system or individual institutions are experiencing funding difficulties of an exceptional nature’ and, therefore, is to be distinguished from the central bank's operations in the short-term money market to implement monetary policy and to ensure the smooth functioning of that market (Quinn 1993). [1]

This paper will confine itself to discussion of the provision of last-resort support by Australian entities. Up until the 1920s, capital flows and parity between the British and Australian pound meant that the Australian banking system was largely an extension of the British financial system. On a number of occasions, Australian banks received last-resort support from the Bank of England. [2]