From lender of last resort to global currency? Sterling lessons for the US dollar

Marc Flandreau, Stefano Ugolini, 23 July 2011



Financial crises are bad news for the status of the currency in which the turmoil is denominated, right?

So the US-made financial crisis must be bad for the dollar, right?

And especially so because of the expansive dollar monetary policy that has ensued, right?

Ambiguity on what “strong currency” means

Several economists appear to be reasoning that way. For instance, according to an article on this site by Buiter and Rahbari (2011), “the US strong-dollar rhetoric has contrasted sharply with a weak dollar reality – which is not surprising given the almost complete absence of any policy measures to support the strong-dollar policy and, especially since the financial crisis, a consistently expansionary monetary policy with predictable (depreciative) exchange-rate consequences”. They conclude from that by “walking a weak-dollar walk” US monetary and fiscal authorities have damaged their “reputational capital”.

Statements such as this reflect the ambiguity of the wording “strong currency”. The exchange-rate response to a crisis that is dealt with through monetary expansion is likely to be a depreciation. But this is not the same as claiming that the “prestige” of the currency has been damaged. Or – to put it in a dramatic way – are prestigious currencies always bound to go up? Doubtful.

A crisis that raised the prestige of sterling

The prestige of a currency is not the same as its exchange rate. As we proceed to argue on the basis of historical evidence, a crisis may actually turn out to be the way to raise the prestige of a currency. This, at the very least, is what happened to the pound sterling after 1866, when the Bank of England fully performed lending of last resort for the first time, thus paving the way for sterling to become the leading international currency.

The so-called Overend, Gurney Panic of 1866 is fascinating today because it is a story about the shadow banking system and money-market funds. In order to fund the rapidly expanding global trade, money-market funds were created during the 1850s and 1860s. They rested on the formula of investing in all kinds of trade bills which were originated from all parts of the world, and securing funding from banks. They were called bill brokers, and they intermediated between the originators of the bills in which they were invested and the banks which funded them. All this structured finance world was leveraged as it should, generating tremendous profits from tiny differences between funding and investment interest rates.

Because of leverage, bill brokers were vulnerable to liquidity shocks. Funding shocks forced liquidations which amplified losses in the usual fashion. Access to the Bank of England liquidity window was thus critical but the Bank of England was reluctant to provide automatic support, fearing moral hazard. This led to conflicting relations between the Bank of England and the bill brokers and even to an open confrontation with the most prominent of these, known as the House of Overend, Gurney.

The upward international trade cycle of the 1860s led to a flurry of additional money-market funds, many of these focusing on trade niches and lending to exporters in foreign countries who sought to take advantage of the very liquid environment in London. The Bank stood by, complaining a lot but not being able to do much. High rates would draw protests from domestic producers without being able to stem the enthusiasm of foreigners for whom such rates still looked like a free lunch, given the generally higher funding costs they faced in their own, more primitive, money markets.

However, when in May 1866 Overend, Gurney proved insolvent, the Bank of England had its revenge. The Bank of England was approached for a bailout but the “Governor took the view that the Bank could not assist one concern unless it was prepared to also assist the many others which were known to be in similar plight”. The result (10th and 11th May, 1866) was the “wildest panic”. Contemporaries compared the event with an “earthquake”, and it is said that it was “impossible to describe the terror and anxiety which took possession of men’s minds for the remainder of that and the whole of the succeeding day”. All transactions were suspended. The financial system ground to a halt as the market stood unsure of what the Bank would do next.

Figure 1. Bank of England supply of liquidity, May 1866

Source: Flandreau and Ugolini (2011).

What it did is shown in Figure 1. Funding was dramatically increased, not so much for the regular customers (the merchant banks and the trading houses) but rather for the commercial banks and – most important of all – for the bill brokers, although these were the ones the Bank was vowed to crush. Few people realise that this experience was really the source of inspiration for Bagehot’s Lombard Street, published 1873, where he theorised the merits of crisis lending, which should be generous, on good collateral, and at high rates (contrary to popular error, he never said “penalty”) (for more details see Bignon et al. 2009).

The extent to which the observed generous lending, which was at fairly high rates, was really on “good collateral” remains to be discussed. Our own research has shown that the Bank could not really monitor the quality of the instruments, so it turned instead on the monitoring of the borrowers – taking larger haircuts, forcing those who required cash to pledge an additional security in the shape of promissory notes and mortgage on their properties, but most of all threatening future exclusion from the discount window (a dangerous threat indeed, as the Bank actually held the monopoly of crisis lending). Such was the way moral hazard was defeated, minimising the risks of adverse selection (only those who knew their portfolio to be secure would accept such conditions).

One of the very many implications these operations had was their effect on sterling as an international currency. At the time when the crisis took place, sterling had many competitors – especially the French franc, a leading currency for trade finance. The relevance of lending of last resort operations for international currency status is underscored in Figure 2, which shows the share of foreign originated sterling instruments discounted by the Bank of England rising above 50% in the late 1850s. By the late 1860s, it was even higher (above 75%). Recent research has also suggested that the primacy of sterling over the franc as the main international currency was definitely affirmed after 1870 – i.e. precisely when, unlike to the Bank of England, the Bank of France proved unwilling or unable to behave as a lender of last resort (Ugolini 2010). In other words, by providing generous liquidity, by supporting the market for sterling bills, and by helping the bill brokers it had promised to crush, the Bank of England really supported sterling as an international currency. It is not irrelevant to remark that at the same time it did this, the Bank of England was released by the British Treasury of the minimum gold reserve requirements, thus putting the convertibility of sterling under heavy strain. Some might have predicted the imminent collapse of sterling – they would have been awfully wrong.

A natural comparison is with the realisation, through numbers released by the Federal Reserve in December 2010, that European banks took a very big slice of Fed aid during the recent crisis. Some European banks (such as Dexia of Belgium or Barclays of the UK) actually ranked among the chief recipients of liquidity provision. In other words, the Fed has found itself in a situation that is not unlike that of the Bank of England in 1866. The reason is that, like it or not, the monetary authorities in charge of international currencies always end up acting as a de facto global lender of last resort. This, we argue, is part of the very process through which the international prestige of currencies is retained or promoted. Of course, a historical difference is that the US Congress may be much less willing to go along with that. The hitch is not the different economics. It is the different politics.

Figure 2. Foreigners in total sterling originations (blue) and in Bank of England discounts (red)

Source: Flandreau and Ugolini (2011).


Flandreau, Marc and Stefano Ugolini (2011), “Where It All Began: Lending of Last Resort and the Bank of England during the Overend, Gurney Panic of 1866”, Norges Bank Working Paper, 2011/03.

Ugolini, Stefano (2010), “The international monetary system, 1844-1870: Arbitrage, efficiency, liquidity”, Norges Bank Working Paper 2010/23.

Bignon, Vincent, Marc Flandreau, and Stefano Ugolini (2009), “Bagehot for beginners: The making of lending of last resort operations in the mid-19th century”, Norges Bank Working paper 2009/22.

Buiter, Willem and Ebrahim Rahbari (2011), “The ‘strong dollar’ policy of the US: Alice-in-Wonderland semantics vs. economic reality”,, 28 June. 

Topics: Economic history, Global crisis, International finance
Tags: Bank of England, economic history, exchange-rate policy, reserve currency, US dollar

Professor, Graduate Institute, Geneva and CEPR Research Fellow
Stefano Ugolini
Assistant Professor of Economics, University of Toulouse

Most Read