Transcript The lender of last resort. Slides to presentation by Jean

THE LENDER OF LAST RESORT
Jean-Charles ROCHET
(IDEI, Toulouse University, France)
Prepared for the conference “Banking Crisis ResolutionTheory and Policy” organized by the Bank of Norway, Oslo
June 16-17th 2005
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INTRODUCTION
Impressive number of banking (and financial) crises in the last
30 years:
 Among IMF member countries: approximately 130 out of
180 have experienced crises or serious banking problems
 Cost of Savings and Loans debacle in the USA (late 1980s)
> loss of all failed US banks during Great Depression
(Calomiris, 1999)
 Average cost of recent banking crises per country:
~ 12 % GDP (but more than 40 % in some cases:
Argentina, Indonesia, Korea, Malaysia).
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Banking crisis
Significant banking
problems
No significant banking
problems/Insufficient
information
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Renewed interest of economic research on:
 The causes of fragility of banks
 The justifications and organization of public intervention,
which can take several different forms:




emergency liquidity assistance by the central bank
closure rules and solvency requirements
deposit insurance
interest rate controls.
Although the different aspects of public
intervention are intrinsically connected, I will focus on the
first point (my assignment today)
the lender of last resort
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First part: survey of the theory and the practice
1 The classical doctrine
Thornton (1802)
Bagehot (1873)
a) lend only against good collateral (Solvent banks)
b) lend at a penalty rate (Illiquid banks)
c) announce readiness to lend without limits (Credibility)
After the panic that followed the Overend - Gurney failure (1866),
LLR operations became standard practice, first in the UK (Barings
crisis, 1890) then in continental Europe.
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Bordo (1990) provides historical evidence of the use of
LLR functions as a way to mitigate banking crises.
Timberlake (1984) shows that US private clearing houses
played a LLR role during the national banking era (1857-1907),
before the creation of the FED and the discount window (1913)
Calomiris (1999), among many others, questions the role of the
IMF as an international LLR.
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2- The Practice: Several Examples

Bank of New York, November 21st, 1985
Computer bug in the bank’s T- Bills clearing system
emergency loan of $ 22.6 billion by the FED:
too much for a single bank, too fast for a consortium.
 Closure of a large bank, followed by Emergency Liquidity
Assistance(ELA) offered to other banks: Herstatt bank, 1974
(German Bundesbank), Barings, 1995 (Bank Of England).
 Intervention to prevent market crashes
 commercial paper run after Penn Central Bankruptcy
in June 1970 (Calomiris 1994)
 Russian bonds default and LTCM crisis in SeptemberNovember 1998 (Edwards, 1999; Furfine 2000)
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
Violations of a): Rescue of Yamaichi Securities, 1965
(Bank Of Japan.)
Secondary Banking crisis in 1973-75 (Bank Of England)
 Difficulty to separate the LLR policy from
banking supervision and closure policy.
 Several well known examples of insolvent banks that were bailed
out either for purely political reasons:
Crédit Lyonnais (1992-96, France), or on contagion grounds:
Continental Illinois (1984, USA), (Johnson-Matthey, 1984, UK).
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In fact, empirical evidence on the resolution of bank
defaults suggests that failing banks are more often
rescued than liquidated.
Goodhart and Schoenmaker (1995): effective methods of
resolving banking problems vary a lot from country to
country but in most cases result in bail outs
Out of a sample of 104 failing banks they find that 73
resulted in rescue and 31 in liquidation
Santomero and Hoffman (1998): in the USA, the
discount window was often used (improperly) to rescue
banks that subsequently failed
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3- Criticisms to the Classical Doctrine

Goodhart (1985): Impossibility of clearly drawing
a line between illiquid and insolvent banks.
 Solow (1982): Central Bank also responsible for
stability of the financial system
 sometimes rescue insolvent banks
 moral hazard
 Kaufman (1991): Public intervention subject to political pressure
and regulatory capture. Discount window = disguised means
to bail out insolvent banks.
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
Goodhart - Huang (1999a): Trade-off between contagion
risk and banks’ moral hazard.
 Rescue insolvent banks above a certain size
(Too Big To Fail) + random intervention
(Constructive Ambiguity).
 Freixas (1999): Make intervention conditional on the amount
of uninsured debt issued by the distressed bank.
Constructive ambiguity limits moral hazard.
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Goodfriend and King (1988)
Monetary Policy
(aggregate liquidity)
Banking Policy
(interventions on
individual banks)
Argue that with modern inter-bank markets, banking policy
has become redundant.
“A solvent bank cannot be illiquid”
LLR could be replaced by private Lines-Of-Credit services
(Goodfriend-Lacker, 1999)
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Second Part: a synthesis of current academic views and
policy recommendations
1-Why do we need a LLR?
Even modern inter-bank markets may not be sufficient to
provide liquidity assistance to banks in trouble. There are
several reasons for that:
Externalities and contagion risk in Large Value Payment
Systems (Freixas et al.2000). The failure of a large bank may
propagate to other banks.
Possible coordination failures on inter-bank markets (RochetVives 2004). Fire-sales premiums or “haircuts” create strategic
complementarities on inter-bank markets. Wholesale investors
may refuse to lend to a bank not because they think it is insolvent
(“fundamental risk”) but because they think other investors will
refuse to do so (“strategic risk”). Solvent banks may be illiquid
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1-Why do we need a LLR? (continued)
Other circumstances in which liquidity provision by interbank markets may be insufficient:
Contagion generated by market incompleteness (Allen-Gale
1998)
Orderly resolution of failures
Macroeconomic shocks
Academic literature has focused on micro-prudential
regulation (how to deal with financial distress of individual
banks)
But public authorities are also concerned by overall financial
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stability (macro-prudential regulation)
2-How to organize emergency liquidity assistance?
For micro prudential purposes, liquidity shocks can be
managed optimally by an ex-ante liquidity requirement and a
system of multilateral credit lines commitments between
banks.
If liquidity shocks have a common component (macro
shock), the CB is needed as a LLR and its collaboration
between the FSA, the DIF and the Treasury has to be carefully
designed.
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MY MAIN MESSAGE TODAY:
• deposit insurance and capital requirements are not
enough
• regulatory/supervisory systems should be reformed,
so as to deal properly not only with individual bank failures
(micro- prudential regulation) but also with systemic
crises( macro-prudential regulation)
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MY MAIN MESSAGE TODAY (2):
Central bank independence for monetary policy
should be extended to lender of last resort activities
Liquidity assistance to the banks in trouble
should be provided under the strict control
of independent supervisory authorities
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3 A MODEL OF PRUDENTIAL REGULATION
Rochet (2004) Adaptation to the banking sector of Holmström-Tirole
(1998)(model of corporate financing)
2 dates t = 0,1; bank lends volume L of loans, financed by deposits D
and equity E. Interest rate normalized to zero.
Deposits insured by Deposit Insurance Fund (DIF) for a premium P .
Macro-shock: additional liquidity need  L
at t = 1/2
E
D
t=0
t=1/2
Moral
Shock? continue Hazard t=1 Success
Stop
Lending
RL  D
Failure
D
0
0
Crucial question: which banks allowed to continue (x=1) and
which banks are closed (x=0) in the event of a shock at date t = 1/2 ?
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Optimal prudential organization in the absence of macroshocks
There are 2 equivalent solutions:
• Public authority: regulates banks’capital and DIF premiums
Banking supervisors close banks that do not comply with
capital requirements
• Private contracting between competing DIFs and the
banker: deposits limited to a certain multiple of banks’capital
insurance premiums set by competition between DIFs.
NB: problem of private DIFs: do not resist in front of systemic
shocks
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Optimal regulation in the presence of macroeconomic
shocks:
separation of banks into two categories:

Banks such that    * (small exposure to macro
shocks) should not be closed in case of macro shock at t=1/2,
but should be subject to a higher capital ratio (than in the
absence of macro shocks)

The banks such that    * (large exposure to macro
shocks) should be closed if a recession occurs and should be
subject to a flat capital ratio
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Implementation: different roles of private investors and
regulators
Private investors only interested by future cash flows:
Only refinance solvent banks (too many closures)
Public regulators subject to political pressure (efficient
lobbying)
Also refinance banks that should be closed
(too few closures).
Public intervention is needed to avoid too many bank
closures but it may lead to forbearance and overinvestment
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4- POLICY RECOMMENDATIONS
Two elements are needed for implementation of the optimal
allocation:
Intervention of the central bank as a lender of last
resort for providing liquidity assistance ( in case of a
recession) to the banks characterized by low macro
exposure.
Preventing extension of this liquidity assistance to
other banks, with higher macro exposure. For these banks
ex post continuation value is positive (from a social
point of view) but bailing them out would be welfare
decreasing from an ex-ante perspective.
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The optimal way to manage emergency provision of
liquidity to banks can be obtained by the following
organization of the regulatory system:
 for each commercial bank, supervisory authorities
evaluate the bank's exposure to macroeconomic shocks
Banks with a small exposure are backed by the DIF and
receive liquidity assistance by the Central Bank in case of
a macro shock.
•They face a capital adequacy requirement and a
deposit insurance premium that increase with macro
exposure
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
Banks with a large exposure to macroshocks are not backed by the DIF: they
should not receive liquidity assistance by the
Central Bank.

They face a flat capital requirement
and a flat deposit insurance premium

The lender of last resort activities of
the central bank are made independent from
political powers: the central bank only
provides liquidity assistance to the banks
that are backed by supervisory authorities.
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CONCLUSIONS (1):
 The main reason behind the frequency and
magnitude of recent banking crises is not deposit
insurance, bad regulation, or incompetence of
supervisors. It is the commitment problem of
political authorities, who are likely to exert pressure
for bailing out insolvent banks and delay crisis
resolution.
 The remedy to political pressure on banks
supervisors is not to substitute supervision by
market discipline: market discipline can only be
effective if absence of government intervention is
anticipated.
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CONCLUSIONS (2):.
Instead the way to restore credibility is to ensure
independence and accountability of bank
supervisors
The other key reform is to restrict liquidity
assistance by the central bank to the banks with low
exposure to macro shocks, that are backed by the
independent supervisors (alternative: cap on macro
exposure).
 Supervisors should be in charge of selecting these
banks, who then would face a capital requirement
and a deposit insurance premium that both increase
with their macro exposure
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CONCLUSIONS (3):
 By contrast, banks with a too high macro
exposure should not be backed by the supervisors
and should not receive liquidity assistance in case of
macro shocks
 Central bank loans should be insured by the
DIF.
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