Do not help insolvent banks. Instead, recognize their situation and treat them like any bankrupt. " The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank ."

." Help solvent banks by lending large amounts freely. A panic will not be stemmed by tiny modicums of liquidity.

Charge penalty rates for rescuing a illiquid but solvent bank (of course this means that the bank is solvent even given the margin for error and the high penalty rates). "Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain."



High rates pull money back into the banking system, and draw gold from abroad. If the assets are truly good, there is some rate at which people will be induced to keep their money in the banking system -- even if they shift it from one bank to another. "If the interest of money be raised, it is proved by experience that money does come to Lombard Street,..." These days, the Fed violates the principle of not lending to insolvent banks, and also the principle of raising rates. Instead, rates are lowered at such times.

Walter Bagehot was editor of "The Economist" in the 1860s. In " Lombard Street: A description of the money market " he explains the workings of Britishbanking system of his time, under a gold-standard currency. Bagehot provides a lot of interesting tid-bits about the founding and evolution of banking. Of most relevance to today is his explanation of the benefits and dangers of fractional reserve banking and his recommendations of how to best manage a flawed system that has a single central-bank.The Bank of England, then private, was thecentral bank. Bagehot laments the statism that put the bank in this position. However, he thinks it is quixotic to think that the fundamental British structure can be changed.Of course any man-made institution can be changed. Nevertheless,, he makes sensible suggestions for managing a central bank. In today's world of powerful central banks Bagehot's book is relevant again.Bagehot contrasts Britain's system with other European ones. In a fractional reserve system, deposits of gold are slowly converted into other materials -- factories, railways and so on, with only a fraction actually remaining in the form of gold, even though the whole of it is subject to a promise to be paid out in gold "on demand". Whatever one might think of the fragility ( or even the honesty ) of such a system, ithave some advantages.Each bank-note represents a de jure claim to gold, but it represents an indirect de facto claim to productive assets. Instead of monetizing gold alone, it monetizes houses, ships, inventories, toll-roads, etc.One role played by money is as a " store of value ". In a fractional-reserve system, productive assets are used as a store of value. Over time, such assets create more value by being put to some use. Two decades later, even though the original machines may be worn and gone, some part of the value produced would have been re-invested in newer machines, in different factories, and so on. The value would have been stored, even though it would have changed physical form.This, notes Bagehot, is the huge benefit of the British system of banking. He says, "In addition to using productive assets as a store of value, this ability to borrow also allows the faster rising of a class of entrepreneurs who do not have sufficient capital of their own. "Bagehot is quite aware of the problems with the English system of fractional-banking: "". It's impossible for individuals to examine and understand the assets and capital structure of every bank whose notes they accept. Since non-gold assets are monetized, these assets may unexpectedly lose value. A bank that has lent unwisely can end up insolvent Further, even if the loans are good, the duration-mismatch is a problem (i.e. the bank has promised to pay out cash "on demand", but cannot call in its loans in short order). If there is an unexpected rise in the demand for money, the money may not be there. "" Even a very solvent bank could be illiquid: it can pay its depositors eventually, but not if they want their money now.From the experience of bank-runs, Bagehot came up with principles a central bank ought to use. He recommends larger fractions be held as reserves by individual banks. For the central bank, he has this advice:This book is not for readers with only a casual interest in the subject, but it is a good source for those who are interested in the history behind our current system, and a great discussion for anyone studying fractional-reserve banking. Few will agree with all Bagehot's advice, but the book offers much wisdom to ponder. A must-read for any serious student of banking.