In the case of solvent institutions, we have known theoretically since Thornton (1802), and probably over a century, as a practical policy, how to deal with that vulnerability in a domestic setting: with central bank LOLR operations, later complemented by deposit insurance. In the current setting, it is far from guaranteed that this process can be replicated at the international level. Of course, in normal times and with developed capital markets, banks can use foreign exchange swap markets to convert domestic liquidity into foreign exchange liquidity speedily and relatively cheaply. However, this process broke down almost completely during the global run on cross-border non-US bank liabilities in the immediate aftermath of the Lehman collapse. In a situation like this, the home central bank’s ability to assist banks to acquire the foreign liquidity denied them on the market and thus avoid a failure of banks to deliver on their foreign currency payments is limited by the size of its reserves or the willingness of the central bank issuing the international currency in question to help. Although the provision of foreign currency liquidity through reserves was clearly important during the crisis, most studies seem to support the conclusion that the dollar swap lines made the crucial difference, especially when they were uncapped vis-à-vis some key central banks. To a significant degree, this was the domestic LOLR process replicated at the international level. Does this mean that we have the solution? At the conceptual level, yes, but at the practical level, maybe not.
On the liabilities side, there are banknotes and coins, deposits from the banks and equity. Image 5: Unconventional monetary policy A stylised balance sheet for a central bank Assets  Liabilities  Foreign assets  Banknotes and coins  Domestic assets  Bank deposits  Lending  Equity  The balance sheet totals of the central banks increased dramatically during the autumn of last year and have remained at approximately these levels since then. A major part of this increase was due to the expansion of lending. BIS Review 41/2009  9  Image 6: Central banks’ balance sheets Percentage of GDP 25  25 ECB BOE  20  20  Federal Reserve Riksbanken  15  15  10  10  5  5  0 jan-07  0 apr-07  jul-07  okt-07  jan-08  apr-08  jul-08  okt-08  jan-09  Sources: Bureau of Economic Analysis, Eurostat, Office for National Statistics, SCB and the respective central banks  As I have mentioned, during the second half of 2008 the Riksbank increased its lending to the banks by more than SEK 450 billion. As a result of the increase in lending, the Riksbank’s balance sheet grew during the second half of 2008 from around SEK 200 billion to around SEK 700 billion, that is it more than tripled. What happened was, put briefly, that when the interbank and securities markets stopped working normally, the demand from the banks for loans and for liquidity reserves at the Riksbank increased.