The lender of last resort role of the central bank is to prevent and mitigate crises.
One definition of lender of last resort (LLR):
-capable and must lend to prevent insolvency when no one else is capable or willing. Also, to
prevent panics. Central bank (CB) is only LLR in monetary systems like those of the US.
-to prevent liquid banks from closing CB should lend on any marketable collateral in the
ordinary course of business when there is no panic.
-CB loans should be made in large amounts on demand at higher than market interest rates to
discourage borrowing that can find accommodation in the market.
-Insolvent financial institutions should be sold at market price or liquidated if no bids, losses
should be borne by owners of equity and so on as in bankruptcy proceedings.
Another purpose would be to prevent panic-induced declines of the money stock.
Now asking six questions:
1. Is CB still only LLR? No other institutions have played this role, US treasury, J.P.
Morgan, private clearing houses. Also, by crisis manager: deals with collective action
problem, acts as leader, through lending shapes actions of other institutions, lends to
maintain institutions whose failure would have systematic consequences. A treasury may
act this role as well as a CB. CB is commonly both crisis lender and crisis manager.
2. Does LLR require the ability to create high-powered money? This definitely helps,
particularly when a run from deposits to currency occurs. In such a case the bank can
provide funds without first round costs to taxpayers. Also, during runs of funds between
institutions LLR will be important to stabilize as its difficult to tell liquid and insolvent
institutions apart. High-power money and thus CBs are better equipped for this issue. Can
also be done by institutions which can provide liquidity to those who want it in crisis to
avoid issues. large reserves or allocated funds. CBs can also be partial LLRs by borrowing
from international market, private or public, or holding large reserves. In modern systems
with a flexible exchange rate CBs are best set to be LLRs.
3. Why does Bagehot insist that LLR lend on good collateral? Collateral that can be
marketed in normal times: it is a quick analysis of whether the institution requesting
liquidity is insolvent in normal times or not. Also avoids moral hazard of excessive risk
holding by potential borrowers as these would not be acceptable collateral.
4. Should there be the penalty rate? Meant to limit demand of credit by institutions not in
trouble, limit moral hazard. Penalty rate meant to be relative to rate of normal times. In
practice LLR have commonly lent at nonpenal rates.
5. Should LLR lend only to market and not individual institutions? Thought to avoid moral
hazard and stop inappropriate saving of institutions from bankruptcy. Should not be general
rule for LLR though because of uncertainty of which institutions should survive and how
insolvency may affect market and system.
6. Should the principles of LLR be stated in advance? General acceptance of constructive
ambiguity which leaves potential borrowers doubtful or uncertain thus reducing moral
hazard.
One definition of lender of last resort (LLR):
-capable and must lend to prevent insolvency when no one else is capable or willing. Also, to
prevent panics. Central bank (CB) is only LLR in monetary systems like those of the US.
-to prevent liquid banks from closing CB should lend on any marketable collateral in the
ordinary course of business when there is no panic.
-CB loans should be made in large amounts on demand at higher than market interest rates to
discourage borrowing that can find accommodation in the market.
-Insolvent financial institutions should be sold at market price or liquidated if no bids, losses
should be borne by owners of equity and so on as in bankruptcy proceedings.
Another purpose would be to prevent panic-induced declines of the money stock.
Now asking six questions:
1. Is CB still only LLR? No other institutions have played this role, US treasury, J.P.
Morgan, private clearing houses. Also, by crisis manager: deals with collective action
problem, acts as leader, through lending shapes actions of other institutions, lends to
maintain institutions whose failure would have systematic consequences. A treasury may
act this role as well as a CB. CB is commonly both crisis lender and crisis manager.
2. Does LLR require the ability to create high-powered money? This definitely helps,
particularly when a run from deposits to currency occurs. In such a case the bank can
provide funds without first round costs to taxpayers. Also, during runs of funds between
institutions LLR will be important to stabilize as its difficult to tell liquid and insolvent
institutions apart. High-power money and thus CBs are better equipped for this issue. Can
also be done by institutions which can provide liquidity to those who want it in crisis to
avoid issues. large reserves or allocated funds. CBs can also be partial LLRs by borrowing
from international market, private or public, or holding large reserves. In modern systems
with a flexible exchange rate CBs are best set to be LLRs.
3. Why does Bagehot insist that LLR lend on good collateral? Collateral that can be
marketed in normal times: it is a quick analysis of whether the institution requesting
liquidity is insolvent in normal times or not. Also avoids moral hazard of excessive risk
holding by potential borrowers as these would not be acceptable collateral.
4. Should there be the penalty rate? Meant to limit demand of credit by institutions not in
trouble, limit moral hazard. Penalty rate meant to be relative to rate of normal times. In
practice LLR have commonly lent at nonpenal rates.
5. Should LLR lend only to market and not individual institutions? Thought to avoid moral
hazard and stop inappropriate saving of institutions from bankruptcy. Should not be general
rule for LLR though because of uncertainty of which institutions should survive and how
insolvency may affect market and system.
6. Should the principles of LLR be stated in advance? General acceptance of constructive
ambiguity which leaves potential borrowers doubtful or uncertain thus reducing moral
hazard.
