The Future of LOLR; What should be done?

If “Blanket Guarantees” are to stay the biggest issue to tackle for LOLR in the future would be the moral hazard problem, discussed in the previous posts. I believe this moral hazard problem will be reduced by the new Basel III framework, which is raising the minimal capital requirements and increasing transparency.

With the lessons of financial crisis learned, the new Basel framework is incentivising an increase in disclosures, which will help to reduce asymmetric information. This will allow identifying the banks that have solvency problems at an early stage and make sure that their failure will not have a catastrophic effect on the financial sector.

The lending in the future should happen at penalty rate that is linked to the economic conditions in the country. Lender of Last Resort should not become the go-to place for banks when they face liquidity problems. An excessive use of the facility can hurt the economy and result in high levels of inflation. I would also speculate that separation of supervisory and central bank’s function in the economy may help to mitigate that. Goodhart and Schoenmaker (1995) found that in countries where these functions are not separate, the inflation is higher.

Furthermore, I would argue that one of the ways to reduce the drawbacks of LOLR facility is to transform it into industry-funded fund, similar to deposit insurance, with mandatory membership and liquidity risk-based premiums. Additional disclosure will help to mitigate problems of asymmetric information; will help to distinguish between good and bad banks. NOT using the taxpayers money and NOT excessively using the printing machine and will get rid of inflation problem and the facility misuse.

LOLR and Financial Crisis. Is it used as Bagehot intended?

Throughout last 30 years, LOLR was used as a main mechanism of providing liquidity to all banks, sometimes with no specific distinction between solvent and insolvent ones. The reason for that, as described in the previous post, is to make sure that the confidence in the banking sector is always strong. There is, however, no evidence of these “Blanket Guarantees” having any impact on liquidity pressures and it has been questioned if doing so is a good idea (Laeven and Valencia, 2008).

During the financial crises, including the most recent one, there is an increased flight to quality with the interest rates on the interbank market increasing and the interbank lending freezing. In case of the European Union Tzitzouris, vice president of Strategas in New York, said  “Banks would rather lend to the ECB than lend to each other, and would rather borrow from the ECB at a higher rate and then lend it right back to the ECB,”.

The role that LOLR played in times of distress is that of a main bail out mechanism that the central banks use. ECB as an example offered an unlimited three-year loans to the European banks in order to make sure they are solvent and to boost demand for high-yielding assets  The Federal Reserve was criticized by US congress for bailing out banks around the world that it knows little about, such as a Libyan-owned bank, Bloomberg reports. It’s obvious that this use of the LOLR facility is far from what was originally described by Bagehot, however, as these actions have not gone unnoticed, it is not likely to continue when the distress is completely over.

Many beleive that the function of the lender of last resort, as performed by the central bank, should also extend to bailing out governments. The problem is specifically critical in the Eurozone countries that got into trouble during the financial crisis. Philip Bodereau, from PIMCO discussed this further in the interview to Bloomberg:

http://www.bloomberg.com/video/77342604-pimco-says-lender-of-last-resort-needed-in-europe.html

Do we REALLY need the LOLR?

Let’s think about why we might NOT need the lender of last resort, and about the problems that it may cause.

Kaufman (1988) suggested that the bank runs can provide discipline to the market. If the bank’s manager knows that there exists a possibility of a bank run, he/she is more likely to keep the level of reserves high so the liquidity risk is reduced. Also it would be more likely that the bank will disclose more information about its loan book, so the depositors would have better information about the risk that the bank is taking. This idea, however, ignores the contagion effect that the bank runs may produce. Run on one of the insolvent banks may result in runs on solvent banks, that would not face it otherwise.

One might also suggest that the presence of deposit insurance in the country would make depositors more confident in safety of their savings and will reduce the number of panics. Therefore, insolvent banks, that should be allowed to fail, will see an increase in bank runs, and the good banks will avoid them. This, however, does not work in practice. As proven by the Northern rock case, depositors do not want to face ANY risks or possible trouble with withdrawal of their money. So as long as there are any rumors about the bank's possible insolvency, they will try to take their money out, no matter how true are these rumors. Although the deposit insurance helps to reduce bank runs it cannot fully substitute the confidence provided by LOLR facility.

The obvious costs of LOLR are inflation and excessive use of taxpayers’ money. There is an incentive for central banks and governments to bail out illiquid or insolvent banks to make sure that nothing damages confidence in the banking system. Therefore, LOLR may be used to bail out banks with little or no good collateral. Where is the bailout money coming from? Well, the government or central bank can print them, use excess reserves or make special provisions in the budget; and like I said, it leads to either inflation or inappropriate use of taxpayers’ money.

Finally, the way that the lender of last resort is used today leads to a Moral Hazard. Meltzer (1986) suggested that the insolvent banks should be allowed to fail; otherwise the risk taken by the banks will be increasing. In other words, if Bankers know that they are going to be bailed out no matter what, they will be willing to take higher and higher risks with depositor’s funds. In the video below, American senator Ron Paul talks about this in one of his statements. I think Moral Hazard problem is the biggest issue of LOLR so far.

Lender of Last Resort: how did it start and what is it all about?

The Lender of Last Resort (LOLR) is currently one of the most important functions of the central banks around the world, the creation of which is attributed to Henry Thornton (1802) and Walter Bagehot (1873). It is designed to prevent the failure of banks that were solvent, but had liquidity problems (not enough cash to give back to depositors when demanded) by giving them an option to take out a loan from the central bank.

Bagehot’s view was that the lending should happen against good collateral (valued at pre-crisis prices) and at a penalty rate. In particular he thought that “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.” (Bagehot, 1873) I think lending at a penalty rate is a logical decision, as it will deincentivise an unnecessary use of the LOLR facility, but may exacerbate the problems of financial sector during recession.

There are many reasons that can lead to bank panics and cause liquidity problems. Bordo (1990) has divided them into the internal and external categories. Internal include fraud, poor management and management dishonesty, external include change in the price level of assets or overall price level. The latter factor is much more relevant to the current financial crisis. Sharp changes in the price level can lead to decrease in value of the investments, which leads to banks raising  additional capital to stay solvent (which might be problematic in the price as selling investment at a pre-crisis price is difficult and interbank lending decreases due to uncertainty).

The best way to understand this concept of LOLR is to have a look at the Pawn Shops that are now lenders of last resort for most of the people. The basic premise is the same as the lending happens against collateral, at a high penalty rate and is only used in case money ore required urgently: