Central bank lending is widely regarded as a vital part of the public safety net supporting the stability of the banking system and financial markets. An independent central bank can provide liquidity to financial institutions on very short notice.l Indeed, central bank lending has been a prominent part of regulatory assistance to troubled financial institutions in recent years. The idea of a central bank as lender of last resort, however, has been around at least since Walter Bagehot wrote about it over 100 years ago.2
For most of that time it was taken for granted that central bank lending had benefits with little or no cost. In the past decade, that view has been challenged. For instance, in the United States the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 recognized that Federal Reserve lending to undercapitalized banks has the potential to impose higher resolution costs on the Federal Deposit Insurance Corporation (FDIC). More recently, the idea that lending by the International Monetary Fund has led to increased risk-taking in international financial markets is being taken seriously by financial market participants and policymakers alike.3 In the United States, financial economists have acknowledged "moral hazard" to be a problem for government financial guarantees ever since the savings and loan crisis of the 1980s.
In this article we look at central bank lending in light of the concerns about moral hazard. Our aim is a practical one: we present principles to help guide central bank lending. Our approach builds on the observation that central bank lending is a publicly provided line of credit. Commercial lines of credit and central bank lending are similar in that both provide substantial funding on very short notice.
Line-of-credit products are complex. We use recent advances in the theory of financial contracts to interpret the structure of loan commitments. By dissecting the incentive implications of the contractual obligations and rights involved in credit lines, we appreciate the tensions present in line-of-credit relationships. In particular, we see how contract terms control the ex post incentives of the borrower and the lender under limited commitment to assure that the line-of credit product is efficient. We then employ our understanding of these issues to benchmark and inform our analysis of central bank lending.
The nature of the problem is this: A line-of-credit product is designed to meet the current obligations of a firm when it is judged to be illiquid though solvent. Inevitably, then, a loan commitment shifts potential losses from shortto longer-term claimants. For instance, a commercial bank's line of credit to an ordinary business has the potential to shift losses to the borrowing firm's long-term bondholders and residual claimants. Analogously, a central bank's line of credit has the potential to shift losses from uninsured creditors to the deposit insurance fund or general taxpayers. Likewise, lending by the International Monetary Fund to finance a country's balance-of payments deficit has the potential to shift losses from short-term creditors of that country to the country's taxpayers.4
Private line-of credit agreements, together with the firm's capital structure, balance the liquidation costs of a conservative lending policy against the moral hazard associated with more liberal lending. Covenant provisions in line-of credit agreements give private lenders the ability and the incentive to constrain credit to insolvent firms when appropriate. In contrast, central banks appear to lack explicit institutional mechanisms to credibly precommit to limit lending. An excessively liberal central bank line of credit makes short-term capital more inclined to move in the direction of favorable yield differentials irrespective of the risk involved, with the idea that the credit line could finance a quick withdrawal.
The inability to commit to limit lending is the principal weakness of central bank lending policy. …