Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation

By Jean-Charles Rochet | Go to book overview

Chapter Three

The Lender of Last Resort:
A Twenty-First-Century Approach

Xavier Freixas, Bruno M. Parigi, and Jean-Charles Rochet


3.1 Introduction

This paper offers a new perspective on the role of emergency liquidity assistance (ELA) by the central bank (CB), often referred to as the lender of last resort (LLR). We take into account two well-acknowledged facts of the banking industry: first, that it is difficult to disentangle liquidity shocks from solvency shocks; second, that moral hazard and gambling for resurrection are typical behaviors for banks experiencing financial distress.

The LLR policy has a long history. Bagehot's (1873) “classical” view maintained that the LLR policy should satisfy at least three conditions: (i) lending should be open only to solvent institutions and against good collateral; (ii) these loans must be at a penalty rate, so that banks cannot use them to fund their current operations; and (iii) the CB should make clear in advance its readiness to lend without limits to a bank that fulfills the conditions on solvency and collateral.

In today's world, the “classical” Bagehotian conception of a lender of last resort has been under attack from two different fronts. First, the distinction between solvency and illiquidity is less than clear-cut. As Goodhart (1987) points out, the banks that require the assistance of the LLR are already under suspicion of being insolvent.1 Second, it has been argued (see, for example, Goodfriend and King 1988) that the existence of a fully collateralized repo market allows central banks to provide the adequate aggregate amount of liquidity and leave the responsibility of lending uncollateralized to the banks, thus giving them a role as peer monitors and introducing market discipline.

These arguments have been so influential that the Bagehot view of the LLR is often seen as obsolete for any well-developed financial system.

1Furfine (2001a) provides empirical evidence oí banks' reluctance to borrow from the
Fed's discount window for fear of the stigma associated with it.

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