Session 3: The role as a lender of last resort
Charles Calomiris, Columbia Business School
Charles Goodhart, London School of Economics
A distinguishing feature of the financial crisis 2007-2009 was that banks were forced to suspend payments are a result of liquidity shortages. In these situations, the central bank plays an important role as lender of last resort. That is, when bank in distress is unable to obtain funding in any other way it can turn to the central bank with requests for some form of extraordinary liquidity assistance.
Charles Calomiris emphasised that explicit laws and regulations are required for the central bank to be able to act as lender of last resort in the best possible way. He mentioned Canada as an example, where regulations already exist as to what type of incident will be met with which type of measure.
Charles Goodhart suggested instead that the central bank should make an assessment of the size of the expected losses when it becomes involved as a lender of last resort. If the losses are expected to exceed a certain amount, the central bank shall require permission from the government before taking measures as a lender of last resort. This is because he says it is not possible to specify an incident of the nature of a crisis in advance.
Charles Goodhart also rejected the idea that the central bank should lend to the market instead of to individual institutions in the event of a crisis. This is because the banks in the market will not want to lend money to a weak bank, which could lead to a downward liquidity spirals. First, the weakest bank fails, then the next weakest and so on.
The moral hazard problem, that is, that the banks take too large risks because they assume they will be saved by the central bank, is best counteracted by dealing most harshly with the first bank to ask for help, as this bank has probably taken the most risks. After that, the central bank must be prepared to save other banks. Another means of counteracting moral hazard is to involve other banks in the rescue action. That is, if other banks want to avoid a systemic risk, they must contribute to the costs.
Finally, the incentives structure needs to be changed. Decision-makers who can influence the banks’ actions should not have freedom from liability.
