Disputed areas Lender of last resort




1 disputed areas

1.1 moral hazard
1.2 macro or micro responsibility
1.3 distinction between illiquid , insolvent
1.4 penalty rate , collateral requirement
1.5 announcement in advance , big fail
1.6 private alternatives





disputed areas

the relevant controversies discussed in section. depending on view 1 favours either of them, design of optimal lender of last resort rather different.


moral hazard

moral hazard has been explicit concern in context of lender of last resort since days of thornton. saving illiquid banks liquidation allowing them borrow central bank can cause excessive risk taking both bankers , investors. therefore, lender of last resort can alleviate current panics in exchange increasing likelihood of future panics risk-taking induced moral hazard.


that report of international financial institution advisory commission accuses imf of doing when lends emerging economies: preventing or reducing losses international lenders, imf had implicitly signalled that, if local banks , other institutions incurred large foreign liabilities , government guaranteed private debts, imf provide foreign exchange needed honour guarantees. investors protected against downside of investment and, @ same time, receive higher interest rates compensate them risk. encourages risk-taking , reduces necessary diversification , led commission conclude, importance of moral hazard problem cannot overstated.


however, not having lender of last resort fear of moral hazard may have worse consequences moral hazard itself. consequently, many countries have central bank acts lender of last resort. these countries try prevent moral hazard other means such suggested stern: official regulation; encouragement private sector monitoring , self-regulation; , imposition of costs on make mistakes, including enforcement of bankruptcy procedures when appropriate. authors suggest moral hazard should not concern of lender of last resort. task of preventing should given supervisor or regulator limits amount of risk can taken.


macro or micro responsibility

whether or not lender of last resort has responsibility saving individual banks has been controversial topic. lender of last resort provide liquidity market whole (through open market operations) or should (also) make loans individual banks (through discount window lending)?


there 2 main views on question, money , banking view: money view, argued, example, goodfriend , king, , capie, suggests, lender of last resort should provide liquidity market open market operations because suffices limit panics. call banking policy (discount window lending) may harmful because of moral hazard. banking view finds in reality market not allocate liquidity efficiently in times of crisis. liquidity provided through open market operations not efficiently distributed among banks in interbank market, , there case discount window lending. in well-functioning interbank market solvent banks can borrow. however, if market not functioning, solvent banks may unable borrow, because of asymmetric information.


a model developed flannery suggests private market interbank loans can fail if banks face uncertainty risk involved in lending other banks. in times of crisis less certainty, however, discount window loans least costly way of solving problem of uncertainty.


rochet , vives extend traditional banking view provide more evidence interbank markets indeed not function goodfriend , king had suggested. main contribution of our paper far has been show theoretical possibility of solvent bank being illiquid, due coordination failure on interbank market.


goodhart proposes discount window lending should considered lending of last resort. reason central banks open market operations cannot separated regular open market operations.


distinction between illiquid , insolvent

according bagehot and, following him, many later writers lender of last resort should not lend insolvent banks. reasonable in particular because encourage moral hazard. distinction seems logical , helpful in theoretical models, authors find in reality, difficult apply. in times of crisis, distinction difficult make.


when illiquid bank approaches lender of last resort, there should suspicion of insolvency. however, according goodhart, myth central bank can evaluate suspicions untrue under usual constraints of time arriving @ decision. obstfeld considers insolvency possibility arises amount of probability, not certain.


penalty rate , collateral requirement

bagehot s reasoning behind charging penalty rates (i.e. higher rates available in market) follows: (1) make lender of last resort last resort , (2) encourage prompt repayment of debt.


some authors suggest charging higher rate not serve purpose of lender of last resort because higher rate make expensive banks borrow. flannery , others mention fed has neither asked collateral nor charged rates above market, in recent years.


announcement in advance , big fail

if central bank announces in advance act lender of last resort in future crises, can understood credible promise , prevent bank panics. @ same time, may increase moral hazard. while bagehot emphasized benefit of promise outweighs costs, many central banks have intentionally not promised anything.


private alternatives

before founding of federal reserve system lender of last resort, role had been assumed private banks. both clearing-house system of new york , suffolk bank of boston had provided member banks liquidity during crises. in absence of public solution private alternative had developed. advocates of free banking view suggest such examples show there no necessity government intervention.


the suffolk bank acted lender of last resort during panic of 1837–39. rolnick, smith , weber argue suffolk bank s provision of note-clearing , lender of last resort services (via suffolk banking system) lessened effects of panic of 1837 in new england relative rest of country, no bank provided such services.


during panic of 1857, policy committee of new york clearing house association (nycha) allowed issuance of so-called clearing-house loan certificates. while legality controversial @ time, idea of providing additional liquidity led public provision of service performed central bank, founded in 1913.


some authors view establishment of clearing-houses proof lender of last resort not have provided central bank. bordo agrees not have central bank. however, historical experience (mainly canada , us) suggested him has public authority , not private clearing-house association provides service.








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