A Lender of Last Resort
The issue of a lender of resort has been commonly studied by many literature materials and experts in last couples of years. It is normally refers to “a institution,
normally is a country’s central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse” (Goodhart and Llling, 2002).
On the other hands, according to Mattews and Booth (2006, p96), “the classic role of
a lender of resort can best be illustrated by referencing the financial crisis.” It can ease
the public fear of a shortage of cash and stop panic to some extent in case that a bank’s liquidity crisis turns into the whole banking crisis or even the financial crisis. And it is so important because it does not only can be encompassed the banking stability, but also the stabilization of the asset markets.
The need for a monetary authority to act as LLR can arise in the case of a banking panic-a widespread attempt by the public to convert deposits into currency and, in response, an attempt by commercial banks to raise their desired reserve-deposit ratios. Banking panics can occur in a fractional reserve banking system when a bank failure or series of failures produces bank runs which in turn become contagious, threatening the solvency of otherwise sound banks.
Two sets of factors, some internal and some external to banks, can lead to bank failures. Internal factors, which affect both financial and nonfinancial enterprises, include poor management, poor judgment, and dishonesty. External factors include adverse changes in relative prices (e.g., land or oil prices) and in the overall price level.
Of the external factors, changes in relative prices can drastically alter the value of a bank’s portfolio and render it insolvent. Banking structure can mitigate the effects of relative price changes. A nationwide branch banking system that permits portfolio
diversification across regions enables a bank to absorb the effects of relative price changes. A unit banking system, even with correspondents, is considerably less effective. The nearly 6000 bank failures that occurred during the decade of the 1920s in the U.S. were mostly small unit banks in agricultural regions. Canada, in contrast, had nationwide branch banking. Consequently, many bank branches in those regions closed, but no banks failed (with the exception of one, in 1923, due to fraud). When a few banks meet with illiquid difficulties, lender of last resort can help and support these insolvent banks to grant emergency loans in many ways, which can reduce monetary contraction and financial risks.
A second external factor that can lead to bank failures is changes in the overall price level (Schwartz, 1988). Price level instability (in a nonindexed system) can produce unexpected changes in banks’ net worth and convert ex ante sound investments into ex post mistakes. Instability means sharp changes from rising to falling prices or from inflation to disinflation. It was caused by gold movements under the pre-1914 gold standard, and, more recently, by the discretionary actions of monetary authorities.
Given that bank liabilities are convertible on demand, a run on an insolvent bank is a rational response by depositors concerned about their ability to convert their own deposits into currency. In normal circumstances, according to one writer, bank runs serve as a form of market discipline, reallocating funds from weak to strong banks and constraining bank managers from adopting risky portfolio strategies (Kaufman, 1988). Bank runs can also lead to a “flight to quality” (Benston and Kaufman et al.,
1986). Instead of shifting funds from weak banks to those they regard to be sound, depositors may convert their deposits into high-quality securities. The seller of the securities, however, ultimately will deposit his receipts at other banks, leaving bank reserves unchanged.
When there is an external shock to the banking system, incomplete and costly information may sometimes make it difficult for depositors to distinguish sound from
unsound banks. In that case, runs on insolvent banks can produce contagious runs on solvent banks, leading to panic. A panic, in turn, can lead to massive bank failures. Sound banks are rendered insolvent by the fall in the value of their assets resulting from a scramble for liquidity. By intervening at the point when the liquidity of solvent banks is threatened-that is, by supplying whatever funds are needed to meet the demand for cash-the monetary authority can allay the panic.
Private arrangements can also reduce the likelihood of panics. Branch banking allows funds to be transferred from branches with surplus funds to those in need of cash (e.g., from branches in a prosperous region to those in a depressed region). By pooling the resources of its members, commercial bank clearing houses, in the past, provided emergency reserves to meet the heightened liquidity demand. A clearing house also represented a signal to the public that help would be available to member banks in time 1 of panic. Neither branch banking nor clearing houses, however, can stem a nationwide demand for currency occasioned by a major aggregate shock, like a world war. Only the monetary authority-the ultimate supplies of high-powered money-could succeed. Of course, government deposit insurance can prevent panics by removing the reason for the public to run to currency. Ultimately, however, a LLR is required to back up any deposit scheme.
Economic theory tells us that the existence of a “visible hand” that substitutes or complements market mechanisms is only justified by the presence of a market failure. Two types of market failures are characteristic to the banking sector: the possibility of a liquidity crisis, and the external effects generated by the failure of a financial institution. The importance of these market failures depends on the economic and financial environment. Thus it is important to consider first the role of the lender of last resort in today’s financial environment, before analyzing the type of institutions that are justified from a theoretical point of view.
Because of the nature of their business, banks accept a liquidity risk by financing their long-term loans with short-term deposits. Therefore a liquidity crisis can arise when depositors decide to withdraw their deposits, thus triggering a bank run. In the absence of an institutional mechanism that corrects it, this behaviour becomes a self-fulfilled prophecy, since, given the banking crisis that ensues, it is rational for depositors to liquidate their deposits. In economic theory a liquidity crisis is modeled as a game with multiple equilibria, with one of them being superior to the others (Diamond and Dybvig, 1983).
The second market failure that justifies the existence of a lender of last resort is the importance of the external effects generated by a bank failure. The failure of financial institutions, and especially the failure of depository ones, greatly exacerbates the importance of these external effects due to the possibility of contagion. Contagion can arise from a change in agents’ expectations about the soundness of the financial system, or it may arise from the creditor and debtor positions that financial institutions have with one another.
A bank failure can affect the behaviour of depositors in other banks, with the risk of a widespread crisis. Two mechanisms can spread the failure of one bank into others: pure speculation and the similarity of their assets
Today’s Financial Environment
Some of the changes that the financial sector has experienced in these last years have contributed to reduce the externalities that justified the existence of the lender of last resort. These changes can be technological; they can affect the liquidity of markets, and/or the behaviour of depositors. Nevertheless, the financial environment has also changed towards a greater internationalization of financial markets, which in turn implies a larger risk of international contagion.
The technological progress in information transmission has led to the development of a liquid market for repurchase agreements (repos) that institutions use to manage their liquidity without credit risk of any kind. Furthermore, innovations in the speed of
information transmission have allowed the development of real-time interbank liquidation systems, to the detriment of the classic systems of compensation and liquidation that entailed a larger interbank risk. Both innovations have thus greatly reduced the risk of contagion.
Nowadays, thanks to a financial regulation that protects better the small investor, in particular, thanks to the generalization of deposit insurance and the direct intervention of the lender of last resort, systemic risk is lower. This comes from the disappearance of purely speculative crises, in which depositors demanded the conversion of their deposits into cash. With the exception of emerging countries, in which a financial crisis can lead to an abandonment of the local currency in favour of a stronger currency, the liquidation of deposits in one bank leads usually to the opening of deposits in another financial institution.
Implications for Institutional Design
Since the intervention of the lender of last resort is justified by the externality created by the failure of a financial institution, an efficient resource allocation entails a limitation of this externality, that is, a limitation of contagion. Taking this into account, one must emphasize that regulation has not insisted enough in the creation of mechanisms that limit contagion between financial institutions, although these mechanisms are already available. For instance, the repos market allows for liquidity management and real time transactions spare the payment system the implicit credit risk.
Analyzing the actions of the lender of last resort, Fischer (1998) identifies two different functions. On the one hand, the lender of last resort acts as a manager of the crisis, coordinating investors and avoiding panics; on the other it is also its responsibility to create the liquidity that the market needs. The implication of this differentiation is important since these two functions could be carried out by different institutions. In fact, in some cases the lender of last resort has acted only as a crisis
manager. Examples of this are the reaction to the 1987 stock market crash or, more recently, the response to the near-collapse of LTCM. In both cases the Fed or the New York Fed helped to coordinate the participants and made it clear that they would inject sufficient liquidity so that agents would not be forced to liquidate their positions. Simultaneously, the possibility of a liquidity crisis justifies the role of the lender of last resort as liquidity provider.
Liberals contend that the origin of the Asian crisis can be found in the implicit guarantees that investors thought they had. It is thus argued that it was the conjunction of high profitability and limited risk due to the likely intervention of the lender of last resort that led to over-investment into emerging economies. The implication is thus that the role of the lender of last resort should have been limited (for instance, during the crisis of Mexico) to avoid the creation of false expectations. Interventionists consider, however, that emerging countries suffered a liquidity crisis when their long-term investments did not allow them to confront their short-term liabilities. Thus, it is said, the intervention of the lender of last resort was necessary and its cost small. Still, as is true at the national level, the international lender of last resort will have to be able to tell apart the solvent but illiquid countries from the truly insolvent ones. Again we think this distinction is not possible.
Just like it happens at the national level, the intervention of the lender of last resort can have an impact on the behaviour of economic agents, with the effect of becoming less efficient due to a moral hazard problem. For debtor countries the possible intervention of the lender of last resort may lead to less discipline in monetary and fiscal policies. For investors, the possible support of the lender of last resort diminishes their incentives to correctly evaluate the country risk if they know that in case of trouble the lender of last resort like it happens at the national level, the intervention of the lender of last resort can have an impact on the behaviour of
economic agents, with the effect of becoming less efficient due to a moral hazard problem. For debtor countries the possible intervention of the lender of last resort may lead to less discipline in monetary and fiscal policies. For investors, the possible support of the lender of last resort diminishes their incentives to correctly evaluate the country risk if they know that in case of trouble the lender of last resort will rescue them. Calomiris (1999) adds that there is a real cost to the interventions of the IMF since these interventions transfer the cost of the crisis from the international investors to the taxpayers of the troubled country, with the subsequent social cost. Nevertheless, as Brealey (1998) points out, in the last crises both the debtor countries and the investors have been severely penalized by the market. From this point of view the importance of the moral hazard argument has been overplayed in the analysis of the crisis.
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