Why do central banks provide liquidity as lender of last resort?

Central banks absorbed COVID-19 shocks through lender of last resort programs.

While asset prices are volatile, the need for liquidity climbs due to margin calls. REPO facilities especially play a vital role in providing short-term liquidity to financial agencies.

Crisis is not the right time to tighten lending conditions. The liquidity shortage causes mass selling of assets and, thus, topples asset prices. While margins are called, asking for additional conditions to provide liquidity would involve the whole system into harsher trouble.

Central banks provide the financial system with necessary liquidity during the COVID-19 period.

Liquidity risk as a result of maturity mismatch

Liquidity risk is in the nature of the banking sector. Financial agencies cannot create value if they always await a crisis. If banks did not transform maturity from short-term to long-term, a considerable part of investments could not be funded. Hence, fewer jobs would be created. Undertaking the liquidity risk, whole society benefits from investment and employment opportunities.

Considering banks as the sole beneficiaries of the maturity transformation is not realistic. Banks are just the intermediaries that profit from the margin between deposit and credit rates. In the absence of maturity transformation, they would still make profit by providing short-term loans.

Financial crises do not distinguish between successful and unsuccessful banks. The most well managed bank of the world would default, if all depositors claim their money at once. Since the financial system is composed of the interdependent and complex connections, an actor’s fail could easily push others into default. In times of crises, there is no way to distinguish between solvent and insolvent actors. Even resilient actors can become insolvent in liquidity shortage. For this reason, crises are not the right time to get rid of bad apples. In normal times, financial institutions can rather be required to increase their liquidity, capital and even profitability ratios.

Crises are like floods or snow slips. Fail of a bank can start a snow slip that devastates the whole economy. Once a bank cannot fulfill its obligations, its counter parties would also fall in liquidity shortage. Mass liquidation of assets sharply decreases collateral prices, triggering mass liquidation of collaterals. Consequently, people loose their houses, jobs and, thus, a whole nation looses its wealth.

Crisis is not the right time to tighten lending conditions. The liquidity shortage causes mass selling of assets and, thus, topples asset prices. While margins are called, asking for additional conditions would involve the whole system into harsher trouble.

What happens in 2008 and 2020

During the 2008 global financial crisis, central banks facilitated the lender of last resort tools. They broadened the type of collaterals accepted. A wide range of collaterals from mortgage-backed securities to corporate bonds was added to the collateral scheme. Thus, the deteriorating asset quality of the banks did not hinder them to lend from the central banks (BIS, 2013).

In the USA, the major non-banks were allowed to reach the Fed funds directly after the fail of Bear Sterns and Lehman Brothers. Being converted to bank holding companies, Goldman Sachs and Morgan Stanley were able to access the liquidity mechanisms of the Fed (Armour, 1999).

Experienced from 2008, central banks responded to the COVID-19 shock by providing endless liquidity. As markets become risk averse, demand for dollars soared. The Fed raised the amount of the REPO facility to 500 billion dollars, satisfying markets. Moreover, it created demand for commercial securities through purchase programs. Thus, financial agencies could fulfill their short-term liabilities.

Why lender of last resort mechanisms are required

Financial institutions cannot be perceived as enterprises working for their own interest. Financial sector is the machine that transforms investments into savings. If this machine stops, creating new jobs and expanding production capacity would not be possible. As a requirement of its mission, financial sector is much more strictly regulated compared to other sectors.

In case regulations do not avoid a crisis, lender of the last resort mechanism should be in effect. A panic does not grow as long as financial institutions are provided with necessary liquidity. Although there is a view that banks could perceive the lender of the last resort mechanism as a hedging opportunity in normal times (Goodhart, 2017), capital and liquidity requirements would discourage such attitudes. Consequently, central banks’ crisis actions such as varying the sort of accepted collaterals and covering all major financial institutions regardless of their legal entity in the LOLR mechanism would be affective to prevent the spillover of the future financial upheavals.

References

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 316-339.

BIS, 2013, “Central Bank Collateral Frameworks and Practices.”. https://www.bis.org/publ/mktc06.pdf

Goodhart, Charles, 2017, “Liquidity Risk Management.“ Financial Stability Review, February 2018: Journal of Human Capital 11, available at https://publications.banque-france.fr/sites/default/files/medias/documents/financial-stability-review-11_2008-02.pdf#page=49.