Advantages and Disadvantages of the Lender Of Last Resort Function - Assignment Example

Explain The Advantages And Disadvantages Of The Lender Of Last Resort (LORL) Function. Should A Bank Be Bailed Out If It Is Believed To Have A Long-Term Solvency Problem? Lender of Last Resort A lender of last resort is basically an institution that is willing to provide loans on the basis of a last resort. The institution that offers such services is usually the country’s central bank (CentralBanksGuide.com 1). A deposit insurance scheme can also become a lender of last resort in the country and the financial safety net. A financial safety net is regarded as an important branch of the financial infrastructure and it is seen to necessitate the promotion of stability of the financial system through the improvement of confidence in the banking system. These financial safety nets have two important elements and they are the deposit insurance schemes and the central bank (Landau and Lindgren 27). The central bank provides the extension of credit to the financial institutions that are experiencing financial difficulties and they are incapable of obtaining the required funds elsewhere (CentralBanksGuide.com 1). In other words, the central bank becomes the last option for financial assistance when the other sources of finance are depleted. The major task of the lender of last resort is to maintain the banking stability and the financial system by offering protection to the individual’s deposited funds. The lender of last resort also prevents unnecessary withdraws by the banks that have temporary limited liquidity (CentralBanksGuide.com 1). For many years, central banks have been attempting to avert great depressions by taking the role of lender of last resort at times of financial difficulties and crisis. The action of lending as the last resort offers liquidity that has a penalty rate. Through the open market operations, the central bank lowers the interest rates on all the safe assets. The process entails support from the market directly (CentralBanksGuide.com 1). The institutions that go for the lender’s assistance are basically the commercial banks. Commercial banks go for such assistance when the financial times are very difficult; the action by the commercial bank is an indication of financial difficulties. The loans are not granted to the commercial banks alone, there are other eligible financial institutions and private companies that may seek the loans. Although this can be the case, the action is sometimes is considered very risky (CentralBanksGuide.com 1). Advantages and Disadvantages of the Lender of Last Resort (LORL) Function Advantages The advantages of the lender of last resort can be found in its policies that have three main objectives and the role of the central bank as a lender of last resort. The policies of the lender of last resort have three main objectives; (a) the protection of integrity of the payment systems, (b) to avert systematic crisis that arises from the spills that run from bank to bank, and (c) prevention of illiquidity at the individual bank from things that lead to its insolvency. The central bank has a role in ensuring that there is enough liquidity in the financial markets (Landau and Lindgren 27). Siebert (306) argues that the central banks have the capability of creating the required liquidity at will. It also has the responsibility of ensuring that the monetary policy objectives are not tampered by the last resort lending (Landau and Lindgren 27). The central bank utilizes three tools to achieve the objectives; these tools vary from country to country in their use. The first tool is lending via the discount window in order to target the help to the particular bank. The second tool is the open market operations and the third and last tool is the public announcements; these tools are used to offer support to the financial systems in general. The importance of these tools as stated earlier varies from nations and the circumstances in that nation (Landau and Lindgren 27). An international lender of last resort can assist nations that require help in the management of a financial crisis when the domestic lender of last resort is absent. The international lender of last resort also takes part if there is existence of corruption from an emerging market nation to the other at times of financial crisis (Mishkin 177). The international lender has the capability of stopping corruption by offering international reserves to the emerging market nations that are threatened by the tentative attacks. The help has the ability to keep the currencies from falling and thus prevention of the spread of financial crisis (Mishkin 178). The existence of such an institution is beneficial to the emerging market nations. This is because these institutions help in the alleviation of contagion and they also prevent possible occurrence and the spread of financial crisis from one emerging market nation to the other. Disadvantages Monetary policy stance of the central bank, the nation’s exchange rate arrangements, degree of market segmentation, the weakness in the system, and the financial system institutional structure can influence their use (Landau and Lindgren 27); this is a disadvantage of the lender of last resort. The mere existence of the lender of last resort resource weakens the risk management incentives the banks. It causes “them to lend more than they otherwise might, and to maintain less liquidity than they would otherwise find appropriate” (Landau and Lindgren 27). The tendency is further motivated by the lender of last resort support for the availability of interest at a subsidized rate (Landau and Lindgren 27). Analysts assert that lender of last resort facility can develop a moral harmful problem. The availability of the loans may motivate the banks to take risks that they did not want to account for (Neave 443). In other words, the central banks tempt the commercial banks to take as much loan as possible whereas the central is protected by the net benefits it collects from the collaterals. Globalization of finance and banking, and the increased of the derivatives can have impact on the bank liquidity and the growth of the international capital flows. These factors have impact on the lender of last resort; they make the demands on the lender of last resort more complex and difficult to assess. The lender of last resort is forced to have access to the relevant supervisory information and this demand for continuous and close contact with the relevant supervisory authority. The dilemma the central bank faces is a disadvantage; the central bank is faced with the problem of whether to offer support to the whole financial system or just the banking system (Landau and Lindgren 27). Should a Bank be bailed out if it is believed to have a Long-Term Solvency Problem? Many economists are of the opinion that the central bank of any country is not supposed to lend individual banks, for example, through the discount window. This is because “the market is as well or better informed than the central bank (CB) about the relative solvency of a bank short of liquidity” (Goodhart and Huang 1060). Provided the collective sufficiency of the high powered money, illiquid banks which are as well as solvent will be capable of borrowing in the inter-bank market; the insolvent banks will be taken out of the system. In addition, the monetary institutions and authorities will have the capability of exercising tolerance and rescue the banks that were not supposed to be shut down. The search for financial stability through direct intervention can divert the central bank from accomplishing its main goal of having control over the monetary aggregates in order to gain price stability (Goodhart and Huang 1060). Bailing the bank can lead to market failure and this can be well illustrated by the Bank of New York. In 1985, the Bank of New York computer stopped working and it could not accept any incoming payments for the dealings in the bond market. The resultant illiquidity inflated to a point that a counterparty bank could not take any risk of getting a sufficiently huge loan. Coordinated syndicate was necessary but such syndicate required time to organize, and the time was very scarce. Another good example is the recent events of the September 11 of 2001; majority of the markets could not function at that time and they were severely disrupted. In the September 11 crisis, the Federal Reserve System enormously enlarged its discount lending window to a majority of the individual banks. In the case of Bank of New York, a large scale want to redirect the reserves presents coordination problems. The commercial counterparty cannot attempt to singlehandedly take the credit risk, and an incentive lacks for the single commercial bank to take the effort, the time and the cost of exercise coordination to sort out the problem (Goodhart and Huang 1060). Thus it will not be appropriate to bail out the bank if it has insolvency problems. If the bank is capable of mitigating the problems, then it will be appropriate to bail out the bank. Coordination failure can be described as the situation in which the bank is illiquid and solvent, but the market is incapable of resolving the difficulty. The difficulty can be temporary if it is resolved rapidly. This is because the credit counterparty limitations obstruct any single institution from doing the required lending and thus, the need for coordinated lending (Goodhart and Huang 1060). There is difficulty in distinguishing between insolvency and illiquidity; this is the same scenario even when the times are normal, that is, there is no financial crisis. The problem can become very difficult and there are concerns that deny liquidity support and it may result in extensive confidence problems that may later on develop into systematic crisis (Landau and Lindgren 28). To maintain the incentive structure and to avoid lender of last resort support from turning into long term funding financial institutions for the bank or becoming the source of central bank loses, the central bank usually lends short term but with a penalty rate and a collateral value attached to it at the precrisis price levels. The situation of a failing bank deteriorates very quickly and in such a circumstance, the lender of last resort continuous support permits the bank to accumulate more losses. The lender of last resort is given protection by the collateral it collects and on the other hand, the bank’s uninsured creditors suffer as a result of the central bank’s activities (Landau and Lindgren 28). In other words, bailing out a bank that has problems with insolvency can further aggregate the problem because the loans are available but with collateral attached to it. The bank accumulates more losses while on the other side the central bank is accumulating benefits from the collateral. Works Cited “Lender of Last Resort." CentralBanksGuide.com. Central Banks, 2011. Web. 12 May 2011. Goodhart, C. A. E. & Huang, H. “The Lender of Last Resort.” Journal of Banking & Finance 29 (2005): 1059-1082. Print. Landau, D. F. & Lindgren, C. Toward a Framework For Financial Stability. Washington, D.C.: International Monetary Fund, 1998. Print. Mishkin, Frederic, S. The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems To Get Rich. Princeton, NJ: Princeton University Press, 2006. Print. Neave, Edwin, H. modern financial systems: theory and applications. Hoboken, NJ: John Wiley and Sons, 2009. Print. Siebert, Horst. The World’s New Financial Landscape: Challenges for Economic Policy. Germany: Springer, 2001. Print. Read More