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chapter one
depositors are after. Yet sometime later the very same lenders/depositors are comfortable and ready to hold short-term bank debt again. Why do depositors’ (or, synonymously, lenders’) beliefs switch from panic to not panic? Causing such a change in beliefs is called “restoring confidence.” With renewed confidence, short-term bank debt can again be used as usual. But how does this happen? How can depositors be convinced that the banking system is solvent and viable? This book is about fighting financial crises. Why is such a book necessary? Don’t we already know how to fight crises? We have Bagehot’s rule. This is the time-honored way to fight crises. The rule was stated by Walter Bagehot in 1873 and says that to end a financial crisis, the central bank needs to lend freely, against good collateral, at a high rate. In the recent crisis, the heads of central banks said that they followed Bagehot’s advice (see King 2010; Draghi 2013; and Bernanke 2014a, 2014b). It is not known why this rule should restore confidence or, in fact, that it does. Everyone pays lip service to Bagehot’s rule. Is Bagehot’s rule useful because it encapsulates everything we need to know about fighting crises? Or, is it that nothing has been learned about fighting crises since 1873? Opening emergency lending facilities has never in itself ended a financial crisis. So the reality is that no lessons have been distilled for fighting crises since 1873. We will see that there is more to restoring confidence than Bagehot’s rule. The gist of Bagehot’s rule is to provide cash to banks with high-interest loans from the central bank that are collateralized with the borrowing bank’s assets. The relatively high interest rate on the borrowed cash prevents banks from taking advantage of the emergency lending opportunity. The banks can then hand out the cash to depositors who withdraw it, and other depositors see that their cash is available. There is a crucial piece of this rule that is implicit and missing from the rule as typically expressed. Bagehot failed to mention it because he was English. The financial structure of banks in Britain kept the identity of borrowing banks secret. This is the crucial missing piece: secrecy. Secrecy about the borrowing banks’ identities hides weak banks, preventing runs against them, which would lead to runs against the next weakest, and so on. This secrecy focuses the attention of households and firms on the key question; is the banking system solvent? In a systemic event, convincing bank debt holders that the system is solvent is what reestablishing confidence means. To understand a crisis and how to fight a crisis, we focus on the US National Banking Era (1863 – 1913). There are three reasons for this. First, once the Civil War ended and the National Banking Acts had fuller impact, it is a homogeneous period during which there were five notable banking panics.
