Liquidity in Resolution - A Transatlantic Perspective on Lender of Last Resort Operations in Bank Resolutions

Abstract

This Article argues that the frameworks put in place to allow for the orderly resolution of large financial institutions suffer from a liquidity problem. This is because post-crisis reforms enjoined central banks from providing liquidity to financial firms during and immediately after resolution. By creating a bright line rule, which essentially prohibited lender-of-last-resort (LOLR) operations once a firm enters resolution proceedings, there is a risk that short-term debt can no longer be rolled over, thereby increasing financial stability risks. As this Article shows, however, there are important differences between the United States (U.S.) and Europe. While the U.S. Congress at least sought to minimize liquidity gaps in resolution by throwing the fiscal firepower of the U.S.’s in the ring, European lawmakers failed to agree on a genuine, common backstop for the resolution of significant credit institutions, only leaving a small window for national solutions. To ensure that the core objectives of resolution, which include allocating losses to equity and long-term debt holders rather than to taxpayers, the central bank should be given a limited LOLR role to shore up the resolved firm’s funding. This LOLR function ought to be guaranteed by the fiscal authority, subject to ex-ante volume limits, and provide only short-term credit. Moreover, to further mitigate latent moral hazard risks and to create a counterweight to the extended LOLR function, the Article advocates for higher capital requirements.