Towards an International Lender of Last Resort
6 Pages Posted: 8 Oct 2014
Date Written: September 2014
In his insightful and comprehensive review of the lender of last resort, Paul Tucker frames the discussion as one of how to best structure the provision of liquidity reinsurance. Because banks provide liquidity insurance in the form of both demandable deposits and callable credit lines, their funding structure puts them at risk of asset fire sales, runs and failure. These have externalities. Fire sales, runs and failures all damage the system as a whole. This creates the need for a liquidity reinsurer. And the only credible reinsurer, the sole entity that can provide liquidity in all states of the world, is the central bank – the lender of last resort.
As fraught as it is, the lender of last resort is an essential element of a financial system that can withstand significant stress and continue to provide services to the economy at large. As Tucker describes in detail, it is possible to design a system that meets society’s financial stability objectives. One that mitigates the moral hazard that leads institutions to sell too much liquidity insurance; moderates the adverse selection that arises from the fact that you only borrow from the central bank if you are desperate; and limits the central bank’s temptation to use access, collateral and haircut rules to allocate credit. That is, it is possible to design a domestic reinsurance system – one in which there is a backstop for intermediaries providing liquidity insurance in the currency of their domestic central bank.
What about transactions in foreign currencies? What if an intermediary issues demandable deposits in a currency other than their domestic money? Who provides the reinsurance then?
Full publication: Re-Thinking the Lender of Last Resort
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