Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis?

Abstract

Liquidity risks are endemic to banks, given the maturity transformation they undertake. This gives rise to risk of bank runs, the first line of defence against which should be appropriate liquidity policy of banks. Nonetheless, solvent banks can face liquidity difficulties at times of stress, necessitating liquidity support. The traditional role of the lender of last resort (LOLR) is to avoid unnecessary failures that could threaten systemic stability, while ensuring that there are suitable safeguards for central bank balance sheets and that moral hazard is minimised. The sub-prime crisis has shown that traditional models of bank liquidity risk and of LOLR require revision, as was already apparent to a lesser extent in the Russia/LTCM episode. Funding risk now interacts with market liquidity risk, to create difficult challenges for central banks. The LOLR has had to adapt radically, for example, in terms of lending to investment banks, taking lower quality collateral and lending for longer maturities. Central banks have also been challenged by difficulties in maintaining confidentiality of support and by the interaction of these problems with low levels of deposit insurance.

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