BIS Papers No 79 Re-thinking the lender of last resort Monetary and Economic Department September 2014 JEL classification: E58, F33 The views expressed are those of the authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2014. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1609-0381 (print) ISBN 978-92-9131-727-1 (print) ISSN 1682-7651 (online) ISBN 978-92-9131-728-8 (online) Contents Overview Rethinking the lender of last resort: workshop summary Dietrich Domanski and Vladyslav Sushko .................................................................................... 1 Keynote paper The lender of last resort and modern central banking: principles and reconstruction Paul Tucker ............................................................................................................................................ 10 Lessons from the lender of last resort actions during the crisis Central banks as lender of last resort: experiences during the 2007–2010 crisis and lessons for the future Dietrich Domanski, Richhild Moessner and William Nelson ............................................. 43 Lessons from lender of last resort actions during the crisis: the Federal Reserve experience William Nelson ..................................................................................................................................... 76 Lender of last resort operations during the financial crisis: seven practical lessons from the United Kingdom Andrew Hauser .................................................................................................................................... 81 Lending of last resort? A European perspective Francesco Papadia .............................................................................................................................. 93 Lender of last resort: actions, results and lessons from Mexico’s experience during the crisis José J Sidaoui ....................................................................................................................................... 97 Lessons from Bank of Japan’s experience during the banking crises of the 1990s and the new dimension to LOLR stemming from the global financial crisis Hiroshi Nakaso .................................................................................................................................. 106 Post-crisis changes in the financial system and their implications for central bank liquidity policies Why central banking should be re-imagined Perry Mehrling ................................................................................................................................... 108 Is there a need to re-think the international lender of last resort? International lender of last resort: some thoughts for the 21st century Jean-Pierre Landau........................................................................................................................... 119 BIS Papers No 79 iii Can emerging economy central banks be market-makers of last resort? Michael Dooley ................................................................................................................................. 128 Toward an international lender of last resort Stephen Cecchetti ............................................................................................................................ 131 iv BIS Papers No 79 Rethinking the lender of last resort: workshop summary Dietrich Domanski and Vladyslav Sushko, BIS Overview Lender of last resort (LOLR) is perhaps a central bank’s most controversial role. On the one hand, emergency liquidity assistance to financial institutions is a core responsibility of central banks. This is because of central banks’ unique ability to create liquid assets in the form of central bank reserves, their central position within the payment system and their macroeconomic stabilisation objective. On the other hand, central bank LOLR is seen as very risky; as it potentially creates moral hazard on a massive scale, exposes the central bank to large financial risks, and blurs the boundary with fiscal policy. Moreover, liquidity assistance to individual institutions is typically deeply unpopular, creating reputation risks. The financial crisis served as a reminder of the critical importance of the LOLR in restoring financial stability. But it also raised fundamental questions about the design of LOLR frameworks and the execution of LOLR policies. How to strike the right balance between limiting risks for central banks and ensuring that the LOLR function can be performed effectively when needed? Should central banks be ambiguous in public about the terms and conditions of liquidity support? Or is there a case for well-articulated LOLR policies, communicated ex ante as part of a broader financial stability framework? This BIS workshop explored these issues, with a view to providing input into the discussions among central banks, and the public debate more generally. While there was broad agreement that liquidity support during the crisis was key in stabilising the global financial system, the discussions highlighted a number of challenges regarding LOLR policies. These included effective ways of dealing with stigma, questions regarding the design of LOLR policies in a market-based financial system, how to contain moral hazard, and issues of governance of LOLR policies, particularly against the backdrop of evolving financial stability frameworks. Finally, the question of optimal mechanisms for liquidity assistance in foreign currency remains an open one. The workshop was organised in three sessions plus a working lunch. The first session, chaired by Hiroshi Nakaso (Bank of Japan), reviewed the experience of major central banks with LOLR measures during the financial crisis. Bill Nelson (Federal Reserve) opened the discussion with an assessment of the Fed’s actions during the crisis. Francesco Papadia (Bruegel) continued the panel with a discussion of how the European Central Bank (ECB) addressed interbank liquidity shortages and wider market dysfunction during the crisis. Andrew Hauser reviewed the Bank of England’s experience during the crisis. José Sidaoui (former Bank of Mexico) provided the perspective of a major emerging market economy (EME), where the foreign exchange market served as a key transmission mechanism of liquidity stress. Hiroshi Nakaso concluded the first session with a review of Bank of BIS Papers No 79 1 Japan experiences during the 1990s banking crises and new aspects of LOLR action that emerged during the recent financial crisis. The second session, chaired by Claudio Borio (BIS), discussed how post-crisis changes in the financial system affected the central bank’s role as LOLR. Perry Mehrling (Columbia University) led off with a discussion of new demands on LOLR associated with a market-based credit system. Lex Hoogduin (University of Amsterdam) discussed the relationship between the LOLR and self-insurance against liquidity risk. Morten Bech (BIS) presented several practical proposals for incorporating liquidity insurance through the central bank into bank liquidity regulation. Tim Lane (Bank of Canada) concluded the panel with a short summary of recent and ongoing work on collateral markets in the Committee on the Global Financial System (CGFS). Sir Paul Tucker (Harvard University) delivered the keynote speech at the working lunch. The speech and the ensuing discussion focused on the issues of LOLR governance. The third session, chaired by Hyun Song Shin (BIS), focused on the international dimensions of LOLR regimes. Jean-Pierre Landau (Sciences Po) opened the panel discussion with a proposal for a multilateral foreign currency liquidity arrangement that would reduce inefficient accumulation of foreign exchange reserves as a means to provide self-insurance. Giovanni Dell’Ariccia (IMF) discussed the relative merits of self-insurance through foreign exchange reserves, bilateral central bank swap arrangements, multilateral arrangements and IMF credit lines. Michael Dooley (University of California) then discussed the constraints that EME central banks faced in obtaining foreign currency insurance. Finally, Steve Cecchetti (Brandeis University) concluded the panel with a discussion of the implications of the US dollar’s role as a reserve currency for the design of international liquidity support arrangements. Summary of the discussions Session 1: Lessons from lender of last resort actions during the crisis The experiences of major central banks with the LOLR role since 2007 had some common characteristics. Major central banks expanded liquidity provision on an unprecedented scale and scope. As the crisis unfolded, LOLR measures evolved from traditional easing of terms at standing facilities to extraordinary actions targeting individual institutions and provision of system-wide support, including to non-bank intermediaries and markets, and liquidity provision in foreign currency. The stabilisation of the financial system since 2009 had allowed central banks to end, or considerably scale back, liquidity support. Overall, discussants characterised the support measures as effective and appropriate in dealing with the extraordinary liquidity stress during the crisis. Yet, the comparison of experiences across major central banks also revealed significant differences. In particular, the design of existing operational