The Effects of Lender of Last Resort on Financial Intermediation during the Great Depression in Japan

During the Great Depression, a series of abrupt bank panics unsettled the Japanese economy from 1931-1932. The Bank of Japan (BOJ) expanded its liquidity provision in response, and yet it restricted access to its liquidity facilities mostly to a select group of banks, with which it had longterm correspondent relationships, rather than making its loans widely available “to merchants, to minor bankers, to this man and to that man” as prescribed by Bagehot (1873). The BOJ’s preferential treatment of correspondent banks along with the sudden occurrence of bank panics provides us with a quasi-experimental setting to examine the impact of Lender of Last Resort (LOLR) policies on financial intermediation in a difference-in-differences framework. We find that deposits and loans did not fall as fast for correspondent banks as for other banks during the bank panic phase of the Great Depression. Furthermore, correspondent banks were less likely to be closed. Japan’s historical experience suggests that central banks’ liquidity provision plays an important backstop role in supporting the essential financial intermediation services in time of financial stringency.