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.