Lender of Last Resort Facilities - Essay Example

The government through its Central Bank provides lender-of-last resort (LLR) facilities to the financial system because the costs of a banking panic are large. The government also does LLR functions to maintain financial stability by implementing specific and directed actions in the monetary system. A country’s central bank is the ultimate provider of currency liquidity in the country’s financial system. The central bank’s role is supported by a law or charter governing its mandated functions.

The Central Bank implements deposit insurance and a capital adequacy standard for banks to make them share in the cost of risk-taking. The Central Bank can grant overnight credit regularly through a standing liquidity facility to banks and non-bank institutions in the financial system as part of its functions. This automatic provision of liquidity assures all participants in the system that they will be able to cover provisional shortfalls in settlement balances.

The Central Bank provides emergency lending assistance to various deposit-taking institutions that are deemed solvent and require additional credit. This assistance is given to institutions that have a significant share of their liabilities as deposits and hold illiquid assets. In an economic crisis where the Governor of a country’s Central Bank believes that there is severe stress on a financial system, he can allow the Bank to be a supplier of liquidity by purchasing securities issued by local and foreign entities.

The Central Bank makes this move to maintain financial stability. (Sharma, 2003) The loans granted by the Central Bank are made on a secured basis. The collateral eligible to secure credit from the Bank refers to highly liquid assets such as government securities. New issues may impact the lender of the last (LLR) resort role. One issue is concerning the expansion of the types of institutions eligible to become members of the financial system and able to participate directly in the payments system.

A second issue is the international linkages created with the entry of foreign bank branches into the country. The third issue is the greater sensitivity to the potential need by local institutions for foreign currency liquidity changes in the supervisory framework. The fourth issue is to craft a lender-of-last resort regime in a globalized banking environment as a way to promote financial stability. The lender of last resort (LLR) facility cannot be handled by the financial banks of the private sector since it will be difficult for private institutions to assess how a given economic crisis will affect all of the financial institutions.

Moreover, the problem of moral hazard is evident for private lenders. To improve LLR efforts, government officials must hammer out strategies to establish a sound supervisory framework which is critical for emergency lending decisions. This supervisory framework brings with it a supervisory role, a supervisory authority, and a strong program of early intervention in financially distressed banks. Without a clear framework, and information-sharing agreements, it is challenging for the Bank to make precise assessments of solvency.

(Daniel et.al., 2005) A strong supervisory framework lessens the incentives for supervisors to delay dealing with a problem in institutions. Other problems of the LLR set-up pertain to solvency concerns as shown by the inability of the financial institution to generate the needed funds from the private sector. In some cases, the collateral used to secure emergency assistance is not of certain value. An international lender of last resort is difficult to establish since it has to deal with various types of foreign currency.

An efficient lender of last resort of a country does two tasks: provide liquidity to cover all obligations within the financial system and to provide a means of intervention whenever and wherever needed to maintain financial stability.