Abstract
AbstractIn this chapter we review the function of the central bank as lender of last resort (LOLR), starting from the understanding of financial crises developed in the previous chapter. We recall long-established LOLR principles: proactive lending, inertia of the central bank risk control framework, and risk endogeneity. Because of its systemic role, a central bank should not tighten its collateral framework in a crisis, as restrictive policies are likely to not only increase the overall damage done by a crisis to society, but to even increase central bank losses. We explain in more detail the main reasons why a central bank should act as LOLR: prevent negative externalities from fire sales; its unique status as institution with unlimited liquidity; its status as a risk-free counterparty making others accept to deliver collateral to it even at high haircuts; and its mandate to preserve price stability. We distinguish three different forms of LOLR: elements built into the regular operational framework; readiness to relax parameters in a crisis; and provision of emergency liquidity assistance to individual firms. We then discuss what could be the optimal propensity of a central bank to engage in LOLR activities and outline possible trade-offs. Last but not least, we develop a bank-run model which highlights the role of asset liquidity and central bank eligible collateral. We calculate through a model variant with binary asset liquidity and uniform central bank collateral haircut, but then also introduce a model variant with continuous asset liquidity and haircuts.
Highlights
While large-scale and successful LOLR measures of central banks can be traced back to at least 1763 (e.g. Bindseil 2019), today’s thinking on the LOLR function is still strongly inspired by nineteenth century experience, and in particular Walter Bagehot’s Lombard Street of 1873
In a hearing of the Lords’ Committee in 1832, Bank of England director Jeremiah Harman summarised the Bank’s actions in the panic of 1825 as follows: We lent... by every possible means, and in modes that we never had adopted before; we took in stock of security, we purchased Exchequer bills, we made advances on Exchequer bills, we discounted outright, but we made advances on deposits of bills to an immense amount; in short, by every possible means consistent with the safety of the Bank;... seeing the dreadful state in which the public were, we rendered every assistance in our power
We identify five reasons for a central bank to act as lender of last resort in a financial crisis
Summary
In this chapter we review the function of the central bank as lender of last resort (LOLR), starting from the understanding of financial crises developed in the previous chapter. We recall long-established LOLR principles: proactive lending, inertia of the central bank risk control framework, and risk endogeneity. We explain in more detail the main reasons why a central bank should act as LOLR: prevent negative externalities from fire sales; its unique status as institution with unlimited liquidity; its status as a risk-free counterparty making others accept to deliver collateral to it even at high haircuts; and its mandate to preserve price stability. We develop a bank-run model which highlights the role of asset liquidity and central bank eligible collateral.
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