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.