Official lender-of-last-resort facilities prevent banking system failure

• Pages: 203-205

Page 203

Dong He: When there are questions about a bank’s solvency, it is important for the public to know that an emergency lender exists.

When a financial institution is confronted with an unexpectedly large increase in the demand for liquidity—that is, when there is a significant run on its deposits—and the institution cannot raise funds on the market quickly enough to offset its losses, it may, as a last resort, turn to the central bank for an emergency loan. Because of recent financial crises around the world—including Mexico in 1994–95, Asia in 1997–98, and Russia in 1998—there has been a resurgence of interest in such emergency liquidity support and its use as a component of public financial safety nets.

An IMF Working Paper, Emergency Liquidity Support Facilities, by Dong He, an Economist in the IMF’s Monetary and Exchange Affairs Department, discusses the operational aspects of official emergency liquidity support. The paper argues that properly defined lending procedures, clearly laid-out authority and accountability, and disclosure rules will promote financial stability, reduce moral hazard, and protect the lender of last resort from undue political pressure.

To avoid moral hazard associated with lender-of-last-resort operations, some central banks maintain a policy of “constructive ambiguity” as to what they will do, how they will do it, and when they will do it. That is, the access to emergency liquidity support facilities is made uncertain, something to be determined ad hoc in each situation. Dong He argues that, although there may well be good reasons to maintain ambiguity over the conditions for assistance, there are important advantages to developing—and for transition economies to follow—a rules-based approach by setting out ahead of time the necessary conditions for support, while maintaining that meeting such conditions is not sufficient for receiving support.

Based on an analysis of selected central bank legislation and regulations and observation of country practices, the paper seeks to draw some lessons by addressing a number of operational questions: Should the operational rules of emergency lending facilities be specified in advance? Should emergency lending operations be disclosed after the fact? What should the terms and conditions for such support be? Should the operational...