Lender of Last Resort Operations During the Financial Crisis: Seven Practical Lessons from the United Kingdom

Abstract

Drawing on the recommendations of the many public reviews of the UK’s experience with lender of last resort (LOLR) operations during the financial crisis, this paper identifies seven practical lessons of wider interest to the central banking community and others. First, lender of last resort operations cannot tackle moral hazard single-handedly: effective alignment of incentives also requires strong microprudential liquid asset requirements and a credible bank resolution regime. Second, the lender of last resort must have a close understanding of the firms to which it might lend, the markets in which they operate and the collateral they have available. Third, ambiguity over the circumstances and terms of LOLR operations may not be as constructive as previously thought: it does not appear to have been effective in limiting moral hazard pre-crisis in the UK, and led to excessive swings in market expectations about the Bank’s willingness to lend. Fourth, as a result, the UK has concluded that the LOLR regime should be richly specified, and embedded in a largely public framework. Fifth, central banks should only lend to solvent institutions – but as a practical matter, illiquidity and insolvency can be hard to distinguish in the midst of a crisis. That requires careful definition of the respective responsibilities of the central bank and the fiscal authority. Sixth, central banks should do all they can to reduce unnecessary stigma associated with their LOLR facilities, whilst recognising that some level of stigma is probably unavoidable. And, seventh, LOLR tools will need to evolve as the post-crisis structure of financial markets becomes clearer. Although some innovation will always be needed in the heat of a crisis, LOLR design can and should be more forward-looking than it was in the pre-crisis era. Key issues include the extent to which central banks should be willing to lend to non-banks, support capital markets and serve as the lenders of last resort in foreign currencies.

Full publication: Re-Thinking the Lender of Last Resort

Keywords: Lender of last resort, central bank discount window, emergency liquidity facilities, constructive ambiguity, moral hazard

JEL Classification: E58, F33