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