18. Adequate policy responses, including emergency liquidity provisions by central banks, helped to solve the liquidity crisis but not the structural insolvency problem (as discussed in Box 1

# **Box 1: ‘Central Bank as the lender of last resort’**

The 2007-2008 financial crisis exposed the scale of actions that central banks can implement in their function as ‘lenders of last resort’. In this role, central banks have at their disposal a variety of tools that should be tailored to address each type of liquidity shortage<sup>1.</sup> The historical (Bagehot) argument<sup>2</sup> regarding central bank interventions states that central banks should lend to solvent banks without limit, against good collateral, at penalty rates. In recent literature<sup>3</sup> , _the role of central banks_ is specified as:

- Guarantors of the entire economy and therefore having the capacity to tackle systemic liquidity risks. They are thus charged with preventing panic-induced collapses of the banking systems and minimizing the costs of bank runs.

- Shock absorbers, but not shock avoiders--by minimizing the secondary repercussions of shocks, averting contagion, spillover or domino effects. Thus, central bank interventions should be restricted to providing temporary liquidity, aimed at breaking the loop between market and funding liquidity risks.

- Temporary supporters of the financial systems, until the structural causes of liquidity risk can be dealt with. This is a very important argument, stressed by Roubini<sup>4.</sup>

Central bank liquidity interventions can act as a buffer against liquidity risk-- to halt the vicious circle between funding and market liquidity--but they cannot resolve banking insolvency (Though in some countries they have attempted to use long term funding by central bank as de facto capital/solvency support). Insolvency and credit crises lead to financial and economic distress that cannot be resolved just with liquidity injections by the LOLR. Moreover, in some jurisdictions (for example, Canada) central banks require a ‘solvency opinion’ by the supervisory agency prior to giving banks access to the LOLR facilities. Almost all central banks require a determination of solvency prior to giving access to the LOLR facilities. This determination is required from a third party when there is a separate banking supervisor. Due to asymmetric information, it is difficult for central banks to distinguish between insolvency and illiquidity and this can lead to adverse selection in lending. By rescuing undeserving institutions (insolvent banks), the central bank can be implicitly penalizing solvent but illiquid banks because it would increase their cost of funding.

Consequently, the _main risk_ of central bank interventions is moral hazard. Providing liquidity during a credit crisis can induce moral hazard as it creates expectations of investors’ bailouts. Moreover, a misallocation of central bank liquidity can promote excessive risk-taking by banks and stimulate risk prone behavior by insolvent banks (‘gambling for resurrection’). For these reasons, in a financial crisis, effective supervision and regulation are the fundamental weapons against systemic risks. They can help central banks discern between illiquid and insolvent banks and can directly act against the causes of liquidity risk.

> 1/ Ceccchetti and Disyatat, _Central Bank Tools and Liquidity Shortages_ , Bank for International Settlements, February 2009.

> 2/ Bagehot, _Lombard street: A description of the money market,_ 1873.

> 3/ Nikolaou, _Liquidity (risk) concepts definitions and interactions_ , European Central Bank, February 2009

> 4/ Roubini, R. ’Worse than LTCM: Not just a liquidity crisis; rather a credit crisis crunch’, _RGE Monitor,_ August 2007.