Lender of last resort: Two Views of the LOLR

Lender of last resort

Lender of last resort: The Financial System Safety Net

Lender of last resort: The EMU System

Lender of last resort: The IMF as International Lender of Last Resort

The classical formulation of the LOLR function goes back to Henry Thornton in 1802 andWalter Bagehot in 1848, and the term goes back even further to Sir Francis Barings, who referred to the Bank of England as the ‘‘dernier resort’’ providing liquidity to banks in times of crisis. Bagehot’s classical formulation as interpreted by Humphrey (1989) and Gaspar (2006) includes the following characteristics:

1. The LOLRhas theobjective of protecting the integrity of the financial system rather than individual institutions;

2. The LOLR supports the central bank’s monetary policy objectives;

3. Insolvent institutions should be allowed to fail;

4. LOLR assistance should be provided to solvent, illiquid institutions;

5. LOLR lending should be granted at penalty rates;

6. LOLR lending should be granted only against good collateral; and

7. Conditions for LOLR lending should be announced and well understood before a crisis event. Although these characteristics lack specificitywith respect to, for example, rate setting, acceptable collateral, and operational definitions of liquidity and solvency, they quite clearly identify the LOLR function as an aspect of monetary policy in times of potential or actual liquidity problems in the economy. Thus, in this classical view, theLOLRstands ready to lend to any entity offering collateral and willing to pay the penalty rate. An example of this LOLR function in practice occurred on September 11, 2001. After the terrorist attacks on New York and Washington, the FederalReserve in theUnited States pronounced its readiness to supply liquidity ‘‘to support the economic and financial system,’’ and the European Central Bank (ECB) also stood ready to ‘‘support the normal functioning of themarkets’’ (see Gaspar 2006).

The more common interpretation of the LOLR, as well as the most commonly practiced role, is that the central bank supplies emergency liquidity assistance to specific financial institutions. In this case, the LOLR function becomes part of the crisis management framework for specific institutions in distress. The requirement that LOLR lending should be reserved for solvent banks facing liquidity problems remains valid under this interpretation. The rationale for this LOLR function is the common view that contagion of one bank’s problem to other solvent banks can occur as a result of the problems of evaluating the risk level of individual banks. Thus LOLR activities become oriented toward specific banks.

The difficulty of distinguishing between liquidity and solvency problems in a banking crisis often leads centralbanks toprovide assistance to insolvent banks. Thereby, the LOLR function of central banks can become the source of moral hazard in banking; if emergency assistance can be expected, bank managers’ incentives to extend risky loans increase. Furthermore, emergency assistance to insolvent banks causes delays in closing the banks. Thereby, the final costs of a bank failure for creditors and taxpayersmay increase.

When a central bank provides liquidity assistance it faces a trade-off between reducing the risk of contagion and reducing the moral hazard problem caused by expectations of aid to insolvent banks.