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Banking5 min read · Updated: 7 November 2026

Walter Bagehot and "Lombard Street": what should a central bank do during a panic?

In May 1866 a large London financial firm suspended payments and the City fell into panic. Seven years later the journalist and economist Walter Bagehot wrote a book about how a central bank should act at such a time. His rules are still at the centre of debate today.

How does a bank panic begin? Usually with one piece of bad news: "such-and-such a firm has suspended payments". After that everyone rushes to take their money back, and even sound banks may be left without cash. Walter Bagehot, who watched one such episode in 19th-century England, gave his famous advice to the central bank precisely for this problem.

Key points

  1. Who was the author? According to Britannica, Walter Bagehot (1826–1877) was an English economist, political analyst and editor of The Economist. According to the history of economic thought page of McMaster University, his book "Lombard Street: A Description of the Money Market" was published in 1873. Lombard Street is the name of the banking street in the City of London.
  2. The event that prompted it: 1866. The Bank of England Quarterly Bulletin (2016) writes that the large bill broker Overend Gurney asked the Bank of England for help on 9 May 1866, but was refused because it was insolvent, and suspended payments on 10 May at 15:30. The City fell into panic.
  3. The Bank rescued the others. According to the Yale Program on Financial Stability, on the day after Overend Gurney suspended payments the Bank of England lent more than 3 million pounds, and about 10 million pounds during the first week, which was more than twice its usual level. In other words, the Bank supported not the insolvent firm but the rest of the system.
  4. Bagehot's rule. The economist Charles Goodhart sums up Bagehot's advice in three short rules: during a panic the central bank should lend freely (a lot), at a high rate, against good collateral. A study by the Federal Reserve Bank of New York points out that Bagehot recommended the rate be "very high".
  5. Why a high rate? A high rate ensures that central bank money goes only to those who really need it: a bank that can find money from another source will not turn to expensive credit. Britannica writes that the book was essentially a tract written to enlarge the central reserve held by the Bank of England and contained the germ of modern central banking theory.
  6. There are debates too. According to Goodhart's 1999 paper, the idea of the "lender of last resort" was present before Bagehot in the works of Henry Thornton; Bagehot's "high rate" is often wrongly interpreted as a "penalty rate"; and in practice it is not easy, during a panic, to separate a bank's temporary lack of cash (a liquidity problem) from its complete insolvency.
  7. Practice today. A study by the Federal Reserve Bank of New York notes that after the events of 11 September 2001 the Federal Reserve lent freely to banks, but at a low rate. So the "lend freely" part of the rule has survived, while the "high rate" part has changed according to circumstances.

Then and now

AspectBagehot's time (1860s–1870s)Today
Lender of last resortThe Bank of EnglandThe state central bank
What money depends onThe gold reserveCentral bank policy
How credit is givenDiscounting bills and lending against securitiesSpecial credit facilities, refinancing operations
Rate"Very high" recommendedDepending on circumstances, sometimes low
Subject of debateThe bank's duty to societyNot encouraging risk-taking (moral hazard)

Example: the "Bodomzor" bank's one-week loan

The calculation below was compiled by the author; both the bank and the rates are hypothetical and do not show the current rate of any country. Interest is calculated by the simple method, with a 365-day year.

Because of a rumour, depositors began withdrawing a lot of money from the "Bodomzor" bank in a single day. The bank's loans and bonds are sound, but it is short of cash. The bank borrowed 150 billion soum from the central bank for 7 days against good collateral (government bonds).

OptionAnnual rate (hypothetical)CalculationInterest for 7 days
Ordinary loan14%150 bn × 14% × 7 ÷ 365≈ 402.7 million soum
Bagehot-style "high rate"20%150 bn × 20% × 7 ÷ 365≈ 575.3 million soum
Difference6 percentage points150 bn × 6% × 7 ÷ 365≈ 172.6 million soum

The price of saving the bank from panic was 172.6 million soum of additional interest for one week. This sum will not bring the bank down, but it encourages it to repay the central bank loan faster as soon as another, cheaper source is found. That is the essence of Bagehot's idea: there should be enough money, but it should not become a "cheap habit". The importance of collateral is also clear: if a bank has no good collateral, under Bagehot's rule it is not lent to.

Link with the previous period: the Bank of England, founded in 1694 to lend to the government, began in the 19th century to turn into the "last support" of the whole banking system. The next stage, the clear separation of central and commercial banks in the 20th century, fixed in law this function that Bagehot had described.

See also

Sources

  1. Britannica Money: Walter Bagehot · Bagehot was born on 3 February 1826 in Langport (Somerset) and died there on 24 March 1877; he was an economist, political analyst and editor of The Economist; "Lombard Street" was a tract written to enlarge the central reserve held by the Bank of England and contained the germ of modern central banking theory
  2. McMaster University, History of Economic Thought: Walter Bagehot · Bagehot's life dates (3 February 1826 – 24 March 1877); "Lombard Street: A Description of the Money Market" was published in 1873
  3. Bank of England Quarterly Bulletin 2016 Q2: The demise of Overend Gurney · Overend Gurney asked the Bank of England for help on 9 May 1866 and was refused because it was insolvent; it suspended payments at 15:30 on 10 May 1866
  4. Yale Program on Financial Stability (New Bagehot Project): Bank of England lending during the Panic of 1866 · on the day after Overend Gurney suspended payments the Bank of England lent more than 3 million pounds, and about 10 million pounds during the first week, more than twice its usual level
  5. Financial Markets Group (LSE), Special Paper 120: C. Goodhart, "Myths About the Lender of Last Resort" (1999) · the idea of the lender of last resort was present in the works of Henry Thornton before Bagehot; Bagehot's proposal of a "high rate" is wrongly interpreted as a "penalty rate"; separating a liquidity shortage from insolvency is not always easy
  6. Federal Reserve Bank of New York, Staff Report No. 217: A. Martin, "Reconciling Bagehot with the Fed's Response to September 11" · Bagehot recommended that the central bank lend at a very high rate; after 11 September 2001 the Federal Reserve lent freely, but at a low rate
  7. The "Bodomzor" bank example · compiled by the author, a hypothetical bank and hypothetical rates; the calculation was checked with Python

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