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Lehman Died, Bagehot Lives: Why Did the Fed and Treasury Let a Major Wall Street Bank Fail?

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Listed:
  • William R. Cline

    () (Peterson Institute for International Economics)

  • Joseph E. Gagnon

    () (Peterson Institute for International Economics)

Abstract

Five years after the Federal Reserve and Treasury allowed the investment bank Lehman Brothers to fail, while rescuing Bear Stearns, Fannie Mae, Freddie Mac, and AIG, their actions (or inaction) remain a focus of debate. Cline and Gagnon present evidence that federal officials, at least in hindsight, appear to have followed the dictum of Walter Bagehot that lending should be granted only to solvent entities. Lehman was insolvent—probably deeply so—whereas the other institutions arguably were solvent. The other institutions had abundant collateral to pledge, whereas what little collateral Lehman had to pledge was of questionable quality and scattered across many affiliated entities. While the Fed and Treasury had a sound reason to let Lehman fail, the shock to financial markets that ensued from its collapse sent the financial crisis into a new, more acute phase and may have contributed to the severity of the Great Recession. Therefore the lesson from Lehman is not only that Bagehot-type lender-of-last-resort action is as important as ever but also that it is critical to ensure an orderly resolution for a systemically important financial institution going bankrupt.

Suggested Citation

  • William R. Cline & Joseph E. Gagnon, 2013. "Lehman Died, Bagehot Lives: Why Did the Fed and Treasury Let a Major Wall Street Bank Fail?," Policy Briefs PB13-21, Peterson Institute for International Economics.
  • Handle: RePEc:iie:pbrief:pb13-21
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. The Lender of Last Resort and the Lehman Bankruptcy
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2016-07-25 17:16:49

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    Cited by:

    1. Paul Tucker, 2014. "The lender of last resort and modern central banking: principles and reconstruction," BIS Papers chapters,in: Bank for International Settlements (ed.), Re-thinking the lender of last resort, volume 79, pages 10-42 Bank for International Settlements.
    2. George Selgin, 2014. "Operation Twist-the-Truth: How the Federal Reserve Misrepresents Its History and Performance," Cato Journal, Cato Journal, Cato Institute, vol. 34(2), pages 229-263, Spring/Su.

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