How far can a Central Bank act as a Lender of Last Resortindependently of Treasury (Ministry of Finance) Support?

By

C.A.E. GoodhartFinancial Markets Group

London School of Economics

Thursday, June 16

I. Should commercial banks in difficulties be encouraged to apply earlier for Central Bank assistance?If so, how?

The very words ‘Last Resort Lending’ imply that all other channels for raising funds have been tried and failed.

Except in the case of a generalised panic, (which needs OMO, not LOLR), it indicates that bank in question has a bad reputation.

But application to CB:-1. Worsens reputation even more, if known, (sign of weakness).2. Invites enhanced supervision.3. Penalty rate, (misreading of Bagehot).

Same with countries applying to IMF:-1. Market dries up.2. Conditionality.

So banks (countries) tend not to go to CB (IMF) until they have used up all other alternatives, and have sold, collateralised or repo-ed best assets.

Implications

(1) More difficult to resuscitate.(2) Greater likelihood of making losses on such loans.

Would it be possible to encourage commercial banks (countries) to go to CB (IMF) earlier?

Perhaps by a gradation of charges (interest rates) both by scale and duration of loan; starting low (subsidised) and becoming penal. CB and IMF loans should not become quasi-permanent; but how can they be off-loaded?

US discount-window mechanism was (inadvertently) somewhat along these lines.

II. Central Banks and their Ministries of Finance

It follows from Section I that LOLR will often run a high risk of loss. (NB in USA Fed could only lend on a fully collateralised basis, so LOLR mostly done in 1980s by FDIC and FSLIC).

LOLR is limited by CB capital. CB can create liquidity, but not capital. Moreover CB’s capital now provided by Government (tax-payer), and Ministers want to be consulted on how used, (Lawson and Johnson Matthey Bank (1984)).

CBs prefer to avoid involving politicians, if possible.

Before end-19th century, CB was often large relative to other commercial banks, e.g. Banque de France, Riksbank, Bank of England. Even so, had to call for help in major crises.

When CB became smaller relative to commercial banks, sought to involve other such banks in rescue. Provider of information, facilitator of joint rescue.

Why do commercial banks agree:-(a) benefit of avoiding panic.(b) threat of CB displeasure.

But (b) is less for foreign banks. US banks in Johnson Matthey case.

So globalisation lessening clout of CBs (except Fed?) and opportunity for ‘private sector’ resolution.

Even so MAB (1982) and LTCM (1998).

In so far as joint action with commercial banks becoming more problematical, CB forced to co-operate in crisis management with Treasury, and also FSA.

Little experience of how this will work:-

USA: FDICIA

UK: Tripartite Standing Committee (1997)

Eurozone: Responsibility at Nation State level

Japan: Problems of co-operation. Delays in Resolution, but total disaster averted by use of funds at last moment.

What will happen when problems become cross-border and international?