Lender of last resort does not imply bailout

The “markets” are demanding that ECB becomes a “lender of last resort”. Even some very famous economists from across the pond are screaming for the ECB to become a “lender of last resort”. In my view ECB is already one, just not one that matches the new twisted definition. The “markets” are not asking just for more liquidity they are demanding a total bailout of a bad system.

I do not want to discuss the pros and cons of having a central bank. Policy making cannot be done in an alternative universe. And even if we agree that having a central bank is not efficient it is almost impossible to abolish it today and continue with our lives. It took time for central banks to appear and if they are to disappear it will only happen with time.

What I want to discuss is one of the central bank’s functions: the lender of last resort. The concept, as many of you know, was introduced by Walter Bagehot in 1873. Basically, the lender of last resort function implies that the central bank provides liquidity to the financial system in times of liquidity crisis. The whole point of this is to prevent bank runs. The mechanism is very simple to understand. The existence of a lender of last resort should ensure, in theory, the depositors that their money (any amount) will be paid back.

It is very important to understand that the lender of last resort only means provider of liquidity and not bailing out banks. Here is why.

The very existence of such a function of a central bank can induce more reckless lending by banks. The lender of last resort acts as insurance and like any insurance can lead to a moral hazard problem. One implication from this is that banks choose to increase the mis-match between their lending and deposit maturities. This is because the existence of a liquidity provider will limit the risk of a sudden deposit withdrawal for a bank and allow the bank to increase profits by more and cheaper short term liquidity to finance longer and more expensive activities (i.e. increasing its margin).

Thus, it could be said that the lender of last resort stimulates risk-taking in the banking sector. This could take different forms. Banks could start lending to business and sectors that would have been judged too risky under different conditions. Or banks could lower their lending standards and charge artificially low interest rates just to acquire market share.

As you can see even the liquidity provider function of a central bank is not risk free. There are plenty of people out there arguing that the combination of cheap liquidity and the guarantee that banks could have unlimited access to it has brought the world in the current mess that it is today. It may be. But I still think there is value to the liquidity provider function especially in extreme times. Of course the function should not be abused and the price of liquidity should come at a very high premium for those banks requiring it. It should not be seen as an easy facility but something that banks use as the last resort and it should really cost them. Shareholders should be able to see that the management of the banks has been reckless and it should force them out. I see value in this function only because it should ensure the depositors that their money will not be lost. In the same time this function should not be used for very long periods of time as it could lead to inflation and hurt depositors one more time.

What I do not see the “lender of last resort” do is: bailouts. Irrespective if we speak of governments or of banks this facility should not exist, especially for governments. My reasoning is very simple. The existence of such a function will induce governments to borrow too. The same principal should be used for banks also. The central bank should not bailout insolvent banks.

I know that there will be people arguing that it is hard to differentiate between insolvent sates and banks and a liquidity crisis. But the same people were trying to convince us that central banks should not try and deflate bubbles and we all know how it ended. To me this is a silly argument. It could be that in the first instance some governments (Greece) look to be insolvent and others (Italy and Spain) do not. But we start with one at a time. The same principle could be used for banks. Some are definitely insolvent some just might have a liquidity problem. The point I am making here is that in some cases providing liquidity is throwing money out the window and in others it might give them a second chance. What we have learned in the recent years is that in the end irrespective of how much liquidity is pushed in the system the insolvent states and banks will falter.

ECB has made some mistakes in the last few years. It was slow to reduce interest rates at the beginning of the current crisis and it tightens monetary policy in response to a transitory inflationary shock. These are mistakes that can easily be corrected. However, the calls for the ECB to bailout euro zone states and banks under the “lender of last resort“ umbrella are irresponsible. It will push the ECB to make a huge mistake. One that might never be corrected.

21 thoughts on “Lender of last resort does not imply bailout

  1. exactly right… But the bailout voices will get louder everyday, begining with bankrupt states and ending with Paul Krugman like analysts… I think that the germans and the ECB, will eventually give in…

  2. States shouldn’t guarantee deposits. In this way, banks will also have to compete based on their solvability rates. This will lead to a much robust and lasting banking system because banks will have to adapt to the new criteria.

    1. As I said, for solutions to make sense they should address the world we live in, not some world imagined by some guys in a coffee house. I already mentioned the moral hazard issue in the post. Unless we allow bankruptcies we will never be able to identify the solvent from the insolvent.

      1. @Florin Citu
        “As I said, for solutions to make sense they should address the world we live in[…] I already mentioned the moral hazard issue in the post.”

        I actually didn’t bother to read your entire article.😛

        My suggestion: break it down into multiple paragraphs. Each paragraph should contain one main idea. Also use sub-headlines to separate different topics.

        Here’s a short tutorial that you may find helpful:
        http://www.ai.uga.edu/mc/WriteThinkLearn.pdf

      2. Adrian, there are 8 paragraphs each with an idea. Granted this was a longer post but the topic demanded it. In the future I will mark the paragraphs clearer. thanks for the presentation though, there is always room for improvement.
        Oh, and refrain your comments until you read the whole post.🙂

  3. So, how do you stop a liquidity problem turning into a solvency one, for the euro area countries, without the help of a central bank?

    And, as you said, if you want solutions to make sense in the world we live in, there’s no “*snap fingers* and every one of them starts having a current account surplus”.

    1. I think if the price of this liquidity “of last resort” is high enough you can hopefully discourage reckless behavior from the start or you can force the banks that have just a liquidity problem to restructure in order to avoid the solvency one. The big issue I am having with what happened after 2008 is that banks were supported, and in some cases motivate (Prima Casa) to do more of the same without any requirements for restructuring. And obviously both banks and governments did, because they felt safe even as the greatest crisis since 1930s was unfolding in front of their eyes.

      1. hopefully discourage reckless behavior from the start

        Well, even though I don’t agree with this description, we are pass this point. And, as we can’t turn back time, I guess my question still stands: what’s to be done now?

      2. I think I lost you🙂 I started with:

        how do you stop a liquidity problem turning into a solvency one,

        and you say we shouldn’t even try? So you hope the problem will solve itself, then?

      3. No, I am saying that the price of liquidity hopefully will force banks and countries into restructuring. IF they have access to free unlimited money they will never change their ways. In fact look at what is happening now with governments. IMF and EU give them cheap liquidity but then impose restructuring. It is not working. The restructuring should be a voluntary decision. And it will happen if the threat of default/bankruptcy is real and credible. .

        What I am saying you cannot stop the liquidity problem turning into a solvency one with polices. It has to be a decision of those in trouble to either reform or go bust.

      4. So you hope, that by promised austerity and restructuring, somehow they’ll be able to start borrow from “the market” at more supportable rates? Why isn’t that working for Spain, after the elections, then?

      5. But this is not happening today. Both banks and euro-zone governments know that yields above 7% will bring the ECB to the rescue (or at least the politicians). This is what Greece used as strategy: wait.
        The threat of default has to be credible and real. Also the risk of borrowing in the markets at yields of 20% or higher has to be real in order for reforms to be implemented.
        Look at the Romanian market. DO you think that the NBR put for RON/EUR (capping it at 3.7 first and then at 4.3) made Romanians shift from borrowing and transacting in EUR to RON? No. They just make some noise and NBR comes to the rescue.
        Until we allow the insolvent ones to fall we will not move on from the current situation.

      6. So “knowing” the ECB will intervene when they’d reach 7% makes the bond market NOT invest in them?!

      7. I don’t know, it doesn’t make any sense to me. Why would the ECB wait to do that at 7% and not at 5%? And by the time they decide that Spain and Italy hovered around 7% enough, France will be over 4%, at this rate.

        But let’s say they will intervene “to the rescue” at 7% (although both Italy and Spain have been at or around that for days, now). What next? Are you saying that the liquidity they’ll get at those yields will not turn into a solvency issue, especially with the growth prospects for the euro area?

        Also, are you saying all these people that keep pushing for ECB to assume lender of last resort status, while the Germans oppose it, are unaware that the ECB will intervene anyway?

        PS Oh and about those “investors” waiting for the yields to rise, not sure who they are, but doubt they’re these guys – “Nov. 8 (Bloomberg) — BNP Paribas SA and Commerzbank AG are unloading sovereign bonds at a loss,[…]Barclays Plc, the U.K.’s second-largest bank by assets, said on Oct. 31 that it cut sovereign-debt holdings of Spain, Italy, Portugal, Ireland and Greece by 31 percent in three months.”

      8. Hey Florin, did you watch Draghi’s press conference today? Hope you did, there was a moment there, when he replied to the 2nd question, that was beautiful in the way it made so clear a point I (and so many others) was trying to make.

        So, the moment he said “oh, and you know last week comments I made, about what might follow the “fiscal compact”, that was interpreted as ECB will start buying (more) bonds? well, you see, we won’t”, from that moment, the yields of Italy and Spain went up 20 bps in a matter of minutes.

        You see, they were down (below 6%) not because the ECB had been buying, but because “The Market” thought that they will, that there is a (secret) cap on yields (he even denied this in the press conference, crystal clear) that the ECB is targeting.

        That’s what so many people are saying: the ECB will not have to buy infinite amounts of bonds, they just have to say, to threaten that they will. Like the Suisse Central Bank, after announcing that “ok, enough with this franc over-valuation” they had to actually intervene less than before, when they were struggling to keep it low. Like the NDGP targeting would work, as explained; like our National Bank has managed to keep the RON so much more stable that our economy would’ve implied, just because so many people know/think that they will intervene, more than the actual intervening.

        Because, you see, it seems nobody likes to mess with Central Banks. Not even The Market.

      9. I did see some of it. Not that moment. It could be that some were just buying up to the meeting expecting ECB would buy and then would have taken their profit. very hard to explain short term movement, there could be few very good reasons. This is the first point.
        On your second point, I do not believe that you can hide a problem long term just with a threat. From time to time they will be called to defend what they preach. Think of Soros, British pound, EMU, Bank of England and Bundesbank.
        Also, Do not be so sure that the fight for weaker RON or stronger Swiss Franc is over. Few battles yes, but as the gold standard, Bretton Woods, and many other “arrangements” supported by the “credible” intervention threats have falter in the face of market forces, so will RON weaken or Swiss Franc strengthen. At some point it is too expensive, not just from a monetary point of view, to keep intervening (direct or just verbally).

        The NGDP story, is something else. I am not sure it is superior to Inflation Targeting. Too much discretion. And I am not sure how would one defend a recession to bring NGDP to target when overshooting. I have a post ready defending an interest rate rule that targets inflation to combat the NGDP. Also, I am uneasy with the assumption of implicit assumption of NGDP targeting that there is no long run money neutrality.

      10. Also, looking at the FX markets it looks like markets are taking the today’s comments and decision as risk of lower growth in the future an lower interest rates (at least short term rates).

  4. Florin, you are making a very good job by constantly reminding us how the (current model of) capitalism should work. Unfortunately the leaders of central banks fear more and more that, by allowing a big bank or a government to default, the economy not only would plunge itself in a new recession, but it will be harder and harder to grow again and create new jobs. They are probably right, but they forget that, by keeping the current irresponsibility in some banks/governments, the entire system is not allowed to correct itself and to evolve in a natural way.

    I read somewhere that a Greek hospital had 50 gardeners while the hospital didn’t had a garden! Maybe if those 50 gardeners wouldn’t have been employed by the state, one of them would have invented something, or at least they would have had to earn their living somehow productively.

  5. Few weeks ago there was some rumours that BNP Paribas faces liquidity problems, more exactly a shortage of dollars caused by some massive withdrawals. At the same time, ECB announced that:
    “The European Central Bank says it loaned $500 million to a single bank for seven days, raising further fears that a major financial institution could be in trouble. The bank said Wednesday on its website that it would make the loan to a single unidentified bidder from its swap line through which it obtains dollars from the U.S. Federal Reserve.”
    Maybe this means to stop a liquidity problem turning into solvency one, but without bailing out the bank. Bailing out the bank would mean that ECB to take BNP’s exposure on greek bonds. Let them to writedown those bonds, the shares to dive as much as the market wants, but prevent bank runs.

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