This study provides an overview of central bank’ “lender of last resort” (LOLR) function. “Lender of last resort” has a very important role in helping the central bank’s monetary policy operating through changes in rediscount rate and refinance rate.
The main purpose of LOLR for all the central banks is to ensure the stability and safety of the commercial banking system. In this paper, I will define central bank and its function. Next, I will evaluate why central banks should be reluctant to act as a lender of last resort.I. IntroductionCentral bank is a public institution that manages a state’s currency, money supply, and interest rates. Central banks have a wide range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment.
Central banks also generally issue currency, function as the bank of the government, regulate the credit system, oversee commercial banks, manage exchange reserves and act as a lender of last resort. However, the role of Central Bank and the scope of its participation may change due to the effect of different laws and the presence of various stakeholders.Thus, US Central Bank does not act as a regulatory body of the financial sector (Driffill et al., 2005), while the intervention activity of Japan Central Bank demand the approval of other governmental bodies (Fujiwara, 2005).
The role of central banks becomes more important in the financial crisis that originated in the United States in summer 2007. Its breadth and potency rapidly increased, spilled over into the global financial system after the collapse of Lehman Brothers in the autumn of 2008. According to Hiroshi Nakaso, the crisis again reminded us of the inherent instability of the financial system and the vicious compounding of problems between the financial system and the real economy.In response, central banks around the world took action, including cuts in interest rates, the provision of ample liquidity, and so-called nontraditional or unconventional measures. Among these, the “lender of last resort” (LLR hereafter) function was the most critical that was carried out by central banks amidst the deepening crisis (Hiroshi Nakaso, 2013).
However, in the current market environment, is LLR effective? That will be followed by a discussion of a few issues pertaining to the central bank’s LLR function. This study tried to determine that central banks should be reluctant to act as a lender of last resort. The remainder of the paper is set out in four sections. In the next section the central bank and its function is reviewed. In the following section, the reason why central bank should limit LLR activities is evaluated.
And the final section concludes.II. The role of central bankCentral banks, acting on behalf of or independently from their governments, can exert over interest rates. The ability of all central banks to exercise any influence over interest rates lies in their role as lenders of last resort.
This in turn relies upon their role as monopoly suppliers of liquidity in the event of a general shortage of funds. No commercial bank or credit institution would dare to assert that in the history of their activities did not have a moment that they were stuck in cash. The massive cash withdrawal (due to low interest rates, high inflation, so the interest rate becomes negative, as can other types of investments have a higher benefit or because there is not enough confidence in banks, etc.) will be easy to make banks insolvent and do not have enough cash to pay for the people.In such cases the commercial banks are no longer lending else, can not recover the loan in time, it would have to the central bank for a loan as a last resort. Chandavarkar (1996 quoted in Geraats, 2002) claims that macroeconomic stabilization is the important role of the Central Bank.
The stabilization tasks include such aspects as the stability of domestic prices and exchange rates as well as domestic payment system. The entry and operation of multinational enterprises in the domestic market as well as the interdependence of the growing domestic economy on the business cycles of other leading global players might create serious financial repression (Geraats, 2002).The challenge is the distortion of prices, including interest rates and exchange rates, which can cause severe fluctuations, create insolvency, and disrupt and threat the domestic economy (Beine et al., 2005). The financial stability is very important for the economic development of the country.
Beine & Bernal (2005) state that in the absence of stability, economy becomes fragile causes a moral hazard and reduces agents’ confidence. According to Ioannidou (2003), in a large number of countries Central Banks combine functions of macroeconomic stabilization with the management of a financial system. In many transition economies the Central Bank acts as the backbone of the financial system, combining both macroeconomic stabilization and micro control of the emerging financial system (Borchgrevink & Moe, 2004).In addition, central banks also act as the lender of last resort. Both Humphrey & Keleher (2002) and Gerdrup (2005) state that acting as central bank’s LLR minimizes the potential risk of disruption of the whole banking system.
For example, in the situation that the market and interest rate volatility can create a problem of insolvency where a single bank might fail to meet its obligations in intra-bank relations. This case might create a domino effect, creating a negative impact on the whole banking system.. According to Borchgrevink & Moe (2004) the central bank should limit LLR activities; I will discuss this issue in the next section.III. Central banks should be reluctant to acts as a lender of last resort.
The concept of LLR came to be widely recognized thanks to Walter Bagehot, who was the editor of the London Economist.1 According to his formulation, one of the most basic principles was that the central bank should be prepared to lend to any “solvent but illiquid” bank so as to prevent the unsettling of the financial system. However, some contemporary economists do not agree with this point of view. They thought that Bagehot’s principle was effective in a financial markets were not as sophisticated, and that it was no longer applicable in the current market environment where market participants have considerable ability to collect and process information.
They believe that in an efficient market, market participants should be able to distinguish clearly between solvency and liquidity issues confronted by their counterparties, which entailed that solvent banks would never face liquidity constraints, negating the need for the central bank to provide LLR functions to individual banks (Hiroshi Nakaso, 2013). In case of the US banks, commercial banks and other financial institutions overestimate the macroeconomic stabilization and the Central Bank support. As a result, they commit to risky portfolios of loans and deposits failing to take into account present market risks. Consequently, the short-term exchange rate fluctuation creates the insolvency problem and creates a necessity for Central Bank to bail out the banks which are in trouble.The threat for macroeconomic stability is that the mass insolvency undermines the Central Bank’s capacity to cover all insolvency issue, meaning the whole financial system might face a crisis. Moreover, the excessive support of banks in terms of LLR activities might induce a form of moral hazard.
Because central bank lend commercial banks a loan with method that be called discount. It is a form of lending through the ‘discount window’. The interest rate of this loan is the discount rate. The central bank is the only bank can not insolvent or in financial trouble, simply because it takes less time to print new money. So it is possible for the banks borrow when they request.
Banks can lend the entire reserve requirement because if necessary it can borrow central bank. The central bank may lend funds for reserve purposes (often known as helping through the ‘discount window’) usually at a pre-announced rate of interest or it may buy short dated non-reserve assets from banks at prices which.The essential point here, however, is that the central bank is the monopoly supplier of funds and it can behave just like any other monopolist. It can either decide on the quantity of reserves to make available, and allow banks to bid between them for the available supply, or it can set the price and supply whatever quantity of reserves is required. In the former case, the quantity is fixed directly and the price follows; in the latter the price is fixed and the quantity demanded follows. Whichever it decides to do, its actions will determine short-term interest rates.
This in turn sets a base to the level of interest rates since commercial banks will not engage in lending at rates which do not at least exceed the rate that they would have to pay for lender of last resort facilities. Suppose that the central bank regulations, though bank lending rate is 10%, but if bank lending under reserve requirement ratio and have to borrow the central bank, central bank will lend loans with an interest rate of 12%.Therefore the banks will consider, if it lend below the reserve requirement ratio with interest rates of 10%, when stuck paying it have to borrow the central bank with higher interest rates. The arbitrage in lending rate will force banks reduced lending, or otherwise reduce the money supply and increase bank reserves to solve the problem when people withdraw. Without a lender of last resort, the only solution would be for banks to hold very high levels of reserves (= cash + banks’ deposits at the central bank) Thus, when the central bank increases the discount rate would reduce the money supply of banking system, it mean reducing the money supply in the entire economy, and versa.
In the role of lender of last resort with the interest rate set by them, central bank used discount rate to regulate the money supply of the banking system and the economy. Borchgrevink & Moe (2004) and Driffill et al. (2003) suggest that the Central Bank should limit LLR activities and force market agents to be more prudent.They state that certain types of risks are not predictable due to the fact that banks borrow short and lend long.
Hence, the sudden inflation scare might cause a dramatic short-term change of rates; induce a tightening of monetary policy and cause insolvency issue of the number of banks. When central banks often perform the role of lender of last resort, they can confuse their regulatory policy. (Assuming now, the economy is in uncertain times and inflation tends to increase, central banks have to use financial instruments to hold interest rates, however, central banks often perform the role of lender of last resort and indirect supply of money in circulation, it not only disable the financial instrument but also pushed up inflation).IV. ConclusionLender of last resort is an important role of central banks.
Under certain conditions, central banks become the last resort for banks which experience insolvency problems. The support of central banks prevents the crisis spreading into and affecting other market agents and the whole economy of a country. Central banks’ LLR function is necessary because the financial market is full of uncertainties. Nowadays, it is the time that market-driven financial intermediation proliferates; the LLR function of central banks has to be broadened, if the stability of the financial system is to be maintained.
Nevertheless, excessive support might cause the effect of moral hazard and lead to an extensive financial crisis. Thus, we should stress the role played by regulation and supervision in order to prevent the accumulation of financial imbalances. It is also necessary to go another step forward and incorporate macro prudential perspectives in central bank actions
