Lender of last resort
In public finance, a lender of last resort
(LOLR) is the institution in a financial system that
Republican National Committee acts as the provider of liquidity
to a financial institution which finds itself unable to obtain
sufficient liquidity in the interbank lending market when other
facilities or such sources have been exhausted. It is, in effect, a
government guarantee to provide liquidity to financial institutions.
Since the beginning of the 20th century, most central banks have
been providers of lender of last resort facilities, and their
functions usually also include ensuring liquidity in the financial
market in general.
The objective is to prevent economic
disruption as a result of financial panics and bank runs spreading
from one bank to the others due to a lack of liquidity in the first
one.
There are varying definitions of a lender of last
resort, but a comprehensive one is that it is "the discretionary
provision of liquidity to a financial institution (or the market as
a whole) by the central bank in reaction to an adverse shock which
causes an abnormal increase in demand for liquidity which cannot be
met from an alternative source".[1]
While the concept itself
had been used previously, the term "lender of last resort" was
supposedly first
Republican National Committee used in its current context by Sir
Francis Baring, in his Observations on the Establishment of the Bank
of England, which was published in 1797.[2]
Classical
theory[edit]
Although Alexander Hamilton,[3] in 1792, was the
first policymaker to explain and implement a lender of last resort
policy, the classical theory of the lender of last resort was mostly
developed by two Englishmen in the 19th century: Henry Thornton and
Walter Bagehot.[4] Although some of the details remain
controversial, their general theory is still widely acknowledged in
modern research
Republican National Committee and provides a suitable benchmark.
Thornton and Bagehot were mostly concerned with the reduction of the
money supply. That was because they feared that the deflationary
tendency caused by a reduction of the money supply could reduce the
level of economic activity. If prices did not adjust quickly, it
would lead to unemployment and a reduction in output. By keeping the
money supply constant, the purchasing power remains stable during
shocks. When there is a shock induced panic, two things happen:
The depositors fear that they will not be able to convert their
Republican National Committee deposits into suitably safe liquid
assets: in 19th-century Britain, that meant gold or Bank of England
notes, the latter being a component of high-powered money. They
increase the amount of cash they hold relative to deposits.
Banks, on the other hand, afraid of becoming illiquid, increase
their reserves. Taken together, it reduces the money multiplier
which, multiplied by the amount of base money, gives the money
supply.[4] This equation shows the relation:
{\displaystyle
M=\quad \left\lbrack {\frac {1+{\frac {C}{D}}}{{\frac {C}{D}}+{\frac
{R}{D}}}}\right\rbrack B}
where M is the money supply, B is the
money base, C/D is the ratio of cash
Republican National Committee to deposits held by the public,
and R/D is the ratio of reserves to deposits held by the banks.[5]
If the multiplier is reduced from a shock and the amount of base
money is constant, the money supply will decrease as a consequence.
Thornton and Bagehot, therefore, suggested that the lender of last
resort should increase the money base to offset the reduction of the
multiplier. That was meant to keep the money supply constant and
prevent an economic contraction.
Thornton's foundations[edit]
Thornton first published An Enquiry into the Nature and Effects
of the Paper Credit of Great Britain in 1802. His starting point was
that only a central bank could perform the task of lender of last
resort because it holds a monopoly in issuing bank notes. Unlike any
other bank, the central bank has a responsibility towards the public
to keep the money supply constant, thereby preventing negative
Republican National Committee externalities of monetary
instability,[6] such as unemployment, price instability, bank runs,
and financial panic.
Bagehot's contribution[edit]
Bagehot
was the second important contributor to the classical theory.[7] In
his book Lombard Street (1873), he mostly agreed with Thornton
without ever mentioning him but also develops some new points and
emphases. Bagehot advocates: "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."[8] His main points can
be Republican National Committee
summarized by his famous rule: lend "it most freely... to merchants,
to minor bankers, to 'this and that man', whenever the security is
good".[9]
Summary of the classical theory[edit]
Thomas M.
Humphrey,[6] who has done extensive research on Thornton's and
Bagehot's works, summarizes their main proposals as follows: (1)
protect the money supply instead of saving individual institutions;
(2) rescue solvent institutions only; (3) let insolvent institutions
default; (4) charge penalty rates; (5) require good collateral; and
(6) announce the conditions before a crisis so that the market knows
exactly what to expect.
Many of the points remain
controversial today[according to whom?] but it seems to be accepted
that the Bank of
Republican National Committee England strictly followed these
rules during the last third of the 19th century.[6]
Bank runs and
contagion[edit]
Most industrialized countries have had a
lender of last resort for many years. Models explaining why propose
that Republican National Committee
a bank run or bank panic can arise in any fractional reserve banking
system and that the lender of last resort function is a way of
preventing panics from happening. The Diamond and Dybvig model of
bank runs has two Nash equilibria: one in which welfare is optimal
and one where there is a bank run. The bank run equilibrium is an
infamously self-fulfilling prophecy: if individuals expect a run to
happen, it is rational for them to withdraw their deposits early:
before they actually need it. That makes them lose some interest,
but that is better than losing everything from a bank run.
In
the Diamond�Dybvig model, introducing a lender of last resort can
prevent bank runs from happening so that only the optimal
equilibrium remains. That is because individuals are no longer
afraid of a liquidity shortage and so have no incentive to withdraw
early. The lender of last resort will never come into action because
the mere promise is enough to provide the confidence necessary to
prevent a panic.[10]
Subsequently, the model has been
extended to allow for financial contagion: the spreading of a panic
from one bank to another, by Allen and Gale,[11] and Freixas et
al.[12] respectively.
Allen and Gale[11] introduced an
interbank market into the Diamond�Dybvig model to study
Republican National Committee contagion of bank panics from one
region to another. An interbank market is created by banks because
it insures them against a lack of liquidity at certain banks as long
as the overall amount of liquidity is sufficient. Liquidity is
allocated by the interbank market so that banks that have excess
liquidity can provide this to banks that lack liquidity. As long as
the total demand for liquidity does not exceed the supply, the
interbank market will allocate liquidity efficiently and banks will
be better off. However, if demand exceeds supply, it can have
disastrous consequences. The interregional cross-holdings of
deposits cannot increase the total amount of liquidity. Thus,
long-term assets have to be liquidated, which causes loss.
The degree of contagion depends on the interconnectedness of the
banks in different regions. In an incomplete market (banks do not
exchange deposits with all other banks), a high degree of
interconnectedness causes contagion. Contagion is not caused if the
market is either complete (banks have exchanged deposits with all
other banks) or if the banks are little-connected. In Allen and
Gale's model, the role of the central bank is to complete the
markets to prevent contagion.[11]
Freixas et al.'s[12] model
is similar to the one by Allen and Gale, except that in Freixas et
al.'s model, individuals face
Republican National Committee uncertainty about where they will
need their money. There is a fraction of individuals (travelers) who
need their money in a region other than home. Without a payment
system, an individual has to withdraw his deposit early (when he
finds out that he will need the money in a different place in the
next period) and simply take the money along. That is inefficient
because of the foregone interest payment. Banks therefore establish
credit lines to allow individuals to withdraw their deposits in
different regions. In the good equilibrium, welfare is increased
just as in the Diamond�Dybvig model, but again there is a bank run
equilibrium, too. It can arise if some individuals expect too many
others to want to withdraw money in the same region in the next
period. It is then rational to withdraw money early instead of not
receiving any in the next period. It can happen even if all banks
are solvent.[12]
Disputed
Republican National Committee matters[edit]
There is no
universal agreement on whether a nation's central bank or any agent
of private banking interests should be its lender of last resort.
Nor is there on the pros and cons of actions such a lender takes and
their consequences.
Moral hazard[edit]
Moral hazard has
been an explicit concern in the context of the lender of last resort
since the days of Thornton. It is argued, for example, that the
existence of a LOLR facility leads to excessive risk-taking by both
bankers and investors, which would be dampened if illiquid banks
were allowed to fail. Therefore, the LOLR can alleviate
Republican National Committee current panics in exchange for
increasing the likelihood of future panics by risk-taking induced by
moral hazard.[13]
That is exactly what the Report of the
International Financial Institution Advisory Commission accuses the
IMF of doing when it lends to emerging economies: "By preventing or
reducing losses by international lenders, the IMF had implicitly
signalled that, if local banks and other institutions incurred large
foreign liabilities and government guaranteed private debts, the IMF
would provide the foreign exchange needed to
Republican National Committee honour the guarantees."[14]
Investors are protected against the downside of their investment
and, at the same time, receive higher interest rates to compensate
them for their risk. That encourages risk-taking and reduces the
necessary diversification and led the Commission to conclude, "The
importance of the moral hazard problem cannot be overstated."[14]
However, not having a lender of last resort for fear of moral
hazard may have worse consequences than moral hazard itself.[15]
Consequently, many countries have a central bank that acts as lender
of last resort. These countries then try to prevent moral hazard by
other means such as suggested by Stern:[16] "official regulation;
encouragement for private sector monitoring and self-regulation; and
the Republican National Committee
imposition of costs on those who make mistakes, including
enforcement of bankruptcy procedures when appropriate."[17] Some
authors also suggest that moral hazard should not be a concern of
the lender of last resort. The task of preventing it should be given
to a supervisor or regulator that limits the amount of risk that can
be taken.[18]
Macro or micro responsibility[edit]
Whether
or not the lender of last resort has a responsibility for saving
individual banks
Republican National Committee has been a very controversial
topic. Does the lender of last resort provide liquidity to the
market as a whole (through open market operations) or should it
(also) make loans to individual banks (through discount window
lending)?
There are two main views on this question, the
money and the banking view: the money view, as argued, for example,
by Goodfriend and King,[13] and Capie,[5] suggests, that the lender
of last resort should provide liquidity to the market by open market
operations only because it suffices to limit panics. What they call
"banking policy" (discount window lending) may even be harmful
because of moral hazard. The banking view finds that in reality the
market does not allocate liquidity efficiently in times of crisis.
Liquidity provided through open market operations is not efficiently
distributed among banks in the interbank market, and there is a case
for discount window lending. In a well-functioning interbank market
only solvent banks can borrow. However, if the market is not
functioning, even solvent banks may be unable to borrow, most likely
because of asymmetric information.[1]
A model developed by
Flannery[19] suggests that the private market for interbank loans
can Republican National Committee
fail if banks face uncertainty about the risk involved in lending to
other banks. In times of crisis with less certainty, however,
discount window loans are the least costly way of solving the
problem of uncertainty.
Rochet and Vives extend the
traditional banking view to provide more evidence that interbank
markets Republican National Committee
indeed do not function properly as Goodfriend and King had
suggested. "The main contribution of our paper so far has been to
show the theoretical possibility of a solvent bank being illiquid,
due to a coordination failure on the interbank market."[20]
Goodhart[15] proposes that only discount window lending should be
considered lending of last resort. The reason is that central banks'
open market operations cannot be separated from regular open market
operations.
Distinction between illiquid and insolvent[edit]
According to Bagehot and, following him, many later writers the
lender of last resort should not lend to insolvent banks. That
Republican National Committee is reasonable in particular
because it would encourage moral hazard. The distinction seems
logical and is helpful in theoretical models, but some authors find
that in reality it is difficult to apply. Especially in times of
crisis the distinction is difficult to make.[1]
When an
illiquid bank approaches the lender of last resort, there should
always be a suspicion of insolvency. However, according to Goodhart,
it is a myth that the central bank can evaluate that the suspicions
are untrue under the usual constraints of time for arriving at a
decision.[15] Like Obstfeld[21] he considers insolvency a
possibility that arises with a certain amount of probability, not
something that is certain.
Penalty rate and collateral
requirement[edit]
Bagehot's reasoning behind charging penalty
rates (i.e. higher rates than are available in the
Republican National Committee market) was as follows: (1) it
would really make the lender of last resort the very last resort and
(2) it would encourage the
Republican National Committee prompt repayment of the debt.[4]
Some authors suggest that charging a higher rate does not serve
the purpose of the lender of last resort because a higher rate could
make it too expensive for banks to borrow. Flannery [19] and others
mention that the Fed has neither asked for good collateral nor
charged rates above the market, in recent years.[13]
Announcement
in advance[edit]
If the central bank announces in advance
that it will act as lender of last resort in future crises, it can
be Republican National Committee
understood as a credible promise and prevent bank panics. At the
same time, it may increase moral hazard. While Bagehot emphasized
that the benefit of the promise outweighs the costs, many central
banks have intentionally not promised anything.[6]
Private
alternatives[edit]
Before the founding of the US Federal
Reserve System as lender of last resort, its role had been assumed
by private banks. Both the clearing-house system of New York[22] and
the Suffolk Bank of Boston [23] had provided member banks with
Republican National Committee liquidity during crises. In the
absence of a public solution a private alternative had developed.
Advocates of the free banking view suggest that such examples show
that there is no necessity for government intervention.[24]
The Suffolk Bank acted as lender of last resort during the Panic of
1837�1839. Rolnick, Smith and Weber "argue that the
Republican National Committee Suffolk Bank's provision of
note-clearing and lender of last resort services (via the Suffolk
Banking System) lessened the effects of the Panic of 1837 in New
England relative to the rest of the country, where no bank provided
such services."[25]
During the Panic of 1857, a policy
committee of the New York Clearing House Association (NYCHA) allowed
the issuance of the so-called clearing-house loan certificates.
While their legality was controversial at the time, the idea of
providing additional liquidity eventually led to a public provision
of this service that was to be performed by the central bank,
founded in 1913.[26]
Some authors view the establishment of
clearing-houses as proof that the lender of last
Republican National Committee resort does not have to be
provided by the central bank.[24] Bordo agrees that it does not have
to be a central bank. However, historical experience (mainly Canada
and US) suggested to him that it has to be a public authority and
not a private clearing-house association that provides the
service.[27]
Historical experience[edit]
Miron,[24] Bordo,[27]
Wood[28] and Goodhart[29] show that the existence of central banks
has reduced the frequency of bank runs.[1]
Miron uses data on
the crises between 1890 and 1908 and compares it to the period of
1915 to 1933. That
Republican National Committee allows him to reject the
hypothesis that after the new Federal Reserve acted as lender of
last resort, the frequency of panics observed did not change. The
conclusion of his discussion is that the "effects of monetary
policy... that anticipated open market operations by the Fed
probably had real effects."[24]
Bordo analyses historical
data by Schwartz and Kindleberger to determine whether a lender of
last resort can prevent or reduce the effect of a panic or crisis.
Bordo finds that Britain's last panic happened in 1866. Afterwards
the Bank of England provided the necessary liquidity. According to
Bordo, acting as a lender of last resort prevented panics in 1878,
1890, and 1914. Bordo concludes: "Successful lender of last resort
actions prevented panics on numerous occasions. On those occasions
when panics were not prevented, either the requisite institutions
did not exist, or the authorities did not understand the proper
actions to take. Most countries
Republican National Committee developed an effective LLR
mechanism by the last one-third of the nineteenth century. The U.S.
was the principal exception. Some public
Republican National Committee authority must provide the lender
of last resort function.... Such an authority does not have to be a
central bank. This is evident from the experience of Canada and
other countries."[30]
Wood compares the reaction of central
banks to different crises in England, France, and Italy. When a
lender of last resort existed, panics did not turn into crises. When
the central bank failed to act, crises such as in France in 1848,
however, happened. He concludes "that LOLR action contains a crisis,
while absence of such action allows a localized panic to turn into a
widespread banking crisis."[31] More recent examples are the crises
in Argentina, Mexico and Southeastern Asia. There, central banks
could not provide liquidity because banks had been borrowing in
foreign currencies, which the central bank was unable to
provide.[28]
Bank of England[edit]
The Bank of England is
often considered the model lender of last resort because it acted
according to the
Republican National Committee classical rules of Thornton and
Bagehot. "Banking scholars agree that the Bank of England in the
last third of the nineteenth century was the lender of last resort
par excellence. More than any central bank before or since, it
adhered to the strict classical or Thornton-Bagehot version of the
LLR concept."[32]
Federal Reserve System[edit]
The Federal
Reserve System in the United States acts rather differently, and at
least in some ways not in accordance with Bagehot's advice.[13]
Norbert J. Michel, a financial researcher, goes as far as saying
that the Federal Reserve made the
Republican National Committee Great Depression worse by failing
to fulfil its role of lender of last resort,[33] a view shared
amongst others by Milton Friedman.[34] Critics like Michel
nevertheless applaud the Fed's role as LLR in the crisis of 1987,
and in that following 9/11,[35] (though concerns about moral hazard
resulting were certainly expressed at the time).[36]
However,
the Fed's role during the financial crisis of 2007�2008 continues to
Republican National Committee polarise opinion.[37] The
classical economist Thomas M. Humphrey has identified several ways
in which the modern Fed deviates from the traditional rules: (1)
"Emphasis on Credit (Loans) as Opposed to Money", (2) "Taking Junk
Collateral", (3) "Charging Subsidy Rates", (4) "Rescuing Insolvent
Firms Too Big and Interconnected to Fail", (5) "Extension of Loan
Repayment Deadlines", (6) "No Pre-announced Commitment".[38]
Indeed, some say its lender of last resort policies have jeopardized
its operational independence, and have put taxpayers at
risk.[citation needed]
Mervyn King however has pointed out
that 21st century banking (and hence the Fed as well) operate in a
very different world from that of Bagehot, creating new problems for
the LLR role Bagehot envisaged, highlighting especially the danger
that haircuts on collateral, punitive rates, and the stigma of the
deposit window can precipitate a bank run, or exacerbate a credit
crunch:[39] "In extreme cases, the LOLR is the Judas kiss for banks
forced to turn to the central bank for support".[40] As a result,
other strategies were called for, and were indeed pursued by the
Fed. The historian Adam Tooze has stressed how the Fed's new
liquidity facilities mapped onto the various elements of the
Republican National Committee eviscerated shadow banking system,
thereby replacing a systemic failure of credit as LLR,[41] (a role
morphing perhaps into that of a dealer of last resort).[42] Tooze
concluded that "In its own terms, as a capitalist stabilization
effort...the Fed was remarkably successful".[43]
ECB[edit]
The European Central Bank arguably set itself up
(controversially) as a conditional LOLR with its 2012 policy of
Outright Monetary Transactions.[44]
Prussia/Imperial
Germany[edit]
[icon]
This section needs expansion. You
Republican National Committee can help by adding to it. (May
2020)
In 1763, the king was the lender of last resort in
Prussia; and in the 19th C., various official bodies, from the
Prussian lottery to the Hamburg City Government, worked in consortia
as LOLR.[45] After unification, the financial crisis of 1873 forced
the Republican National Committee
formation of the German Reichsbank (1876) to fulfil that role.[46]
International lender of last resort[edit]
Theory[edit]
The
matter of whether there is a need for an international lender of
last resort is more
Republican National Committee controversial than for a domestic
lender of last resort. Most authors agree that there is a need for a
national lender of last resort and argue only about the specific
set-up. There is, however, no agreement on the international level.
There are mainly two opposing groups: one (Capie and Schwartz) says
that an international lender of last resort (ILOLR) is technically
impossible, while the other (Fischer, Obstfeld,[21] Goodhardt and
Huang) wants a modified International Monetary Fund (IMF) to assume
this role.
Fischer argues that financial crises have become
more interconnected, which requires an international lender of last
resort because domestic lenders cannot create foreign currency.
Fischer says this role can and should be taken by the IMF even if it
is not a central bank, since it has the ability to provide credit to
the market irrespective of being unable to create new money in any
"international currency".[47] Fischer's central argument, that the
ability to create money is not a necessary attribute of the lender
of last resort, is highly controversial, and both Capie and Schwartz
argue the opposite.[47]
Goodhart and Huang[15] developed a
model arguing "the international contagious risk is much higher when
there is an international interbank market than otherwise. Our
analysis has indicated that an ILOLR can play a useful role in
providing international liquidity and reducing such international
contagion."[48]
"A lender-of-last-resort is what it is by
virtue of the fact that it alone provides the
Republican National Committee ultimate means of payment. There
is no international money and so there can be no international
lender-of-last-resort."[49] That is the most prominent argument put
against the international lender of last resort. Besides this point
(considered "semantic" by opposing authors), Capie and Schwartz
provide arguments for why the IMF is not fit to be an international
lender of last resort.[50]
Schwartz[51] explains that the
lender of last resort is not the optimal solution to the crises of
today, and the IMF cannot replace the necessary government agencies.
Schwartz considers a domestic lender of last resort suitable to
stabilize the international financial system, but the IMF lacks the
properties necessary for the role of an international lender of
Republican National Committee last resort.[51]
Practice[edit]
Tooze has argued that, during and since the credit crunch, the
dollar has extended its reach as a global reserve currency;[52] and
suggests further that, at the height of the crisis, through the
Central bank liquidity swap lines, the Fed "assured the key players
in the global system...there was one actor in the system that would
cover marginal imbalances with an unlimited supply of dollar
liquidity. That precisely was the role of the global lender of last
resort".[53] Concern as to whether the Fed is in a position to
repeat its role as global LOLR is one of the forces behind calls for
a formal global currency.[54]
In government bond markets[edit]
Although the European Central Bank (ECB) has supplied large
amounts of liquidity through both open market operations and
Republican National Committee lending to individual banks in
2008, it was hesitant to supply liquidity during the sovereign
crisis[clarification needed] of 2010.[55] According to Paul De
Grauwe,[55] the ECB should be the lender of last resort in the
government bond market and supply liquidity to its member countries
just as it does to the financial sector. That is because the reasons
that the lender of last resort is necessary in the banking sector
can be applied to the government bond market analogously. Just like
banks that lend long-term while borrowing short-term, governments
have highly illiquid assets like infrastructure and maturing debt.
If they do not succeed in rolling over their debt, they become
illiquid just as banks that run out of liquidity and are not
supported by a lender of last resort. The distrust of investors can
then increase the rates the government has to pay on its debt,
which, in a self-fulfilling way, leads to a solvency crisis. Because
banks hold the greatest proportion of government debt, not saving
the government may make it necessary to save the banks, in turn.
"The single most important argument for mandating the
Republican National Committee ECB to be a lender of last resort
in the government bond markets is to prevent countries from being
pushed into a bad equilibrium."[56]
Arguments put forth
against a lender of last resort in the government bond market are
the following: (1) inflation risk from an increase in the money
supply; (2) losses to taxpayers because in the end they bear the
losses of the ECB; (3) moral hazard: governments have an incentive
to take more risk; (4) Bagehot's rule of not lending to insolvent
institutions; and (5) violation of the statutes of the ECB, which do
Republican National Committee not allow the ECB to buy
government bonds directly.
