Lender of Last Resort

inSight

11 Oct 2007

Lender of Last Resort

There are advantages in central banks acting as both Lender of Last Resort and banking supervisor.

The financial turmoil in the developed markets in Europe and America caused by the US sub-prime mortgage problem will, in the coming months, stimulate a lot of discussion over what went wrong, the lessons to be learnt, and the remedies. This will likely be a discussion of global interest, even though contagion to the emerging markets has been limited up to now. There are, I am sure, valuable lessons to be learnt by the emerging markets, particularly about what not to do, as they continue to embark on financial liberalisation and financial innovation.

Inevitably the discussion will also focus on the roles of central banks and supervisory authorities in the maintenance of financial stability, and how best this important work should be organised, including the pros and cons of institutional separation of the central bank and the banking supervisor. The recent trend, if one can be discerned, is for separation, with some prominent examples of this taking place in the developed markets, although the arguments for doing so have not been convincingly articulated. There is a lingering impression in those jurisdictions that have gone for separation and among observers interested in the governance arrangements of central banks and supervisory authorities that the trend has been very much coloured, if not initiated, by political motives.

Whether or not a central bank is also the banking supervisor, it is clear that the role of Lender of Last Resort is for the central bank. It is inevitable that occasional stresses in the financial system will lead to a shortage of liquidity to an extent beyond the ability of the banks to handle on their own. The central bank, as the only institution able to create liquidity in the banking system, has an important role to play as Lender of Last Resort, particularly if the liquidity problem threatens systemic stability. Such systemic liquidity problems, if allowed to persist could lead to a general tightening of credit that would have adverse implications for the economy. However, the role of Lender of Last Resort entails significant moral hazard because the central bank might be seen as too willing to underwrite the banking system and bail out banks that are not as well run as others, indirectly encouraging imprudent practices.

There is no internationally accepted approach to this dilemma because the banking systems in different jurisdictions have very different characteristics. Countries that rely on their banking systems to meet the bulk, if not all, of the financial intermediation needs of their economies will understandably have different attitudes to those with diversified and integrated channels of financial intermediation. In any case, I think the central bank should play the role of Lender of Last Resort as transparently as possible. Transparency has a useful tranquillising effect on those, including of course depositors, who may, for one reason or another, have worries about the banking system or individual banks. Readers may be aware of our very clear stance on the role of the Hong Kong Monetary Authority as Lender of Last Resort and how we discharge that role. This is articulated in a policy statement published in June 1999. It sets out the conditions for receiving Lender-of-Last-Resort support, the instruments that can be used and other operational details.

I also think that there is a need for the central bank to have a mechanism to monitor closely the financial positions of individual banks, if only so that it can decide quickly whether Lender-of-Last-Resort support is justified. It is essential for the central bank to act quickly when a liquidity or a banking crisis looms to contain it, or if possible nip it in the bud. There may even be a need for the Lender of Last Resort to develop standing arrangements with individual banks to maintain maximum readiness. I think this is best achieved when the central bank is also the banking supervisor. The flow of information within one organisation is much smoother than that between two, particularly if they operate under different legal frameworks, where provisions for central-bank and banking-supervisor independence may represent barriers to the effective and timely flow of vital information.

Joseph Yam
11 October 2007

 

 

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