Principles and goals: A European lender of last resort?

Introduction

Financial crisis management in the single financial market of the European Union is a subject which is required attention. As one of the key objectives of the political, economic, monetary and legal integration of the EU’s 25 member states, the single financial market is becoming a reality with the increased integration of national financial systems. While EU market liquidity and efficiency are no doubt improving, financial disturbances are now more likely to affect more than one member state. Furthermore, while European national financial systems are becoming systemically integrated, the EU’s financial-stability structure is still based primarily on the exercise of national responsibilities. The most important question we can set at this time is: Are these national responsibilities capable to solve cross-border financial disturbances?

The recent crises thus have brought the role of a European lender of last resort, which raises some important questions. Do we need a European lender of last resortCould domestic central banks instead perform this role, as is the traditional view Then how should the European Lender of Last Resort operateWhat are the principles that should follow the European lender of last resort if it is to be effective Who should be the European lender of last resortShould the ECB do it and if so, does it need to be reformed to perform this role effectively. Alternatively, should another organization take the role of one European lender of last resort?

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The importance of Lender of last resort and its principles.

Firstly as a crucial benchmark we will discuss the alternative views of a lender of last resort.

Under the classical view of Thornton and Bagehot the monetary authority in the face of a panic should lend freely but at penalty rate to illiquid but only solvent banks, denying aid to insolvent banks no matter how large or important. The banking panic occurs when the public want to convert deposits into currency. When a bank does not have adequate liquidity there is a bank run which in turn become contagious, under asymmetry information, threatening other solvent and sound banks. Bagehot stated four principles for the bank to observe as a lender of last resort to the monetary system: First, lend at a penalty rate, make clear Bank’s readiness to lend freely, the latter principle shows the importance to prevent financial crises at the beginning of a disturbance, and lastly accommodate anyone with good collateral at a pre-panic prices and prevent illiquid but solvent banks from failing but as Meltzer argues not to take greater risks.

Goodfriend and King argue that the lender of last resort should function under an open market operation. Goodfriend regards governments provided deposit insurance as a substitute for the portfolio diversification of a nationwide branch banking system. By itself, deposit insurance without a lender of last resort commitment to provided high powered money in times of distress is insufficient to protect the banking system.

Charles Goodhart advocates temporary central bank assistance to insolvent banks. He argues that the distinction between illiquidity and insolvency is a myth since banks requiring lender of last resort support because of illiquidity will in most cases already be under suspicion about solvency. As Solow also argues, any bank failure, especially a large one, reduces confidence in the whole system. To prevent the latter the central bank should provide assistance to insolvent banks as well. However such a policy creates a moral hazard problem as banks take greater risk and public do not have an incentive to monitor them.

Last view of lender of last resort is the free banking. Its proponents denied the need of any government authority. The reason of banking panics is legal restrictions on the banking system. The most important restrictions are the prohibition of nationwide branch banking and the prohibition of free currency issue by the commercial banking system.

As referred above, an adequate liquidity in one bank can cause bank run. If the interbank market not be able to shield banks from such an occurrence, a single bank run can spread to other banks and the contagious effect would take place, and may cause a systemic banking crisis. The provision of emergency liquidity by the central bank, as a lender of last resort may protect banks against these incidents. While the central banks of most countries act as a lender of last resort, the European Union treaty has left the identity of Lender of last resort open in the EMU.

Asymmetric information plays a crucial role in the financial banking system. In financial crises leads to disastrous consequences for the economy as it makes the situation worse. At this point central banks should intervened preventing systemic risk.

In most developed countries, domestic central banks have the ability to act as a lender of last resort and lend freely during a financial crisis. The key features are that the institutional structure of financial systems has debt contracts that there are almost solely denominated in domestic currency. Conversely the central banks of developing countries do not have this capability and if they have is limited. Many developing countries have much of their debt denominated in foreign currency. Thus, there is a strong argument that a lender of last resort may play a crucial role in most developing countries at times of financial crises. Although there is a need of one European lender of last resort, it does create a serious moral hazard problem that may worsen financial crises.

Thus a recovery from a financial crisis in a developing country is required foreign assistance which would help to stabilize the value of the domestic currency which strengthens domestic balance sheets. Furthermore there is a case that one developing country contagious financial crisis to another developing country. However a European lender of last resort has the ability to stop contagion by providing reserves to these markets and help them keep their currencies unaffected. Recent problem of such kind of example is the case of Greece where IMF provides reserves to help avoid failure and reduce the possibility to contagious other countries in Europe.

The existence of a European lender of last resort creates a moral hazard problem because depositors and other creditors do not have an incentive to monitor banks that is, they know if a crisis occurs their deposits would be secured by deposit insurance system. As a result these banks without monitoring and withdrawals from depositors encouraged to take excessive risks which make financial crises more likely.

Thus to limit the moral hazard problem by a European lender of last resort and help it cope with financial crises more effectively, we introduce some ways for the European lender of last resort to operates better.

First and the most important, is restore confidence to the financial system. Without confidence depositors would withdraw their funds if they suppose that their bank is illiquid even though it is not. Some rumors transfer the bank run from one illiquid bank to the whole system and distress financial economy. Restoring confidence is essential to keeping the financial system operating efficiently. That is the key to preventing financial crisis.

Provide liquidity to restart the financial system. Injecting liquidity is effective if we provide liquidity as fast as possible. The faster the lending, the lower is the amount that has to be lent. The need for quick provision of liquidity to keep the amount of funds manageable suggests that credit facilities at a European lender of last resort must be designed to provide funds quickly. Also the resolution and recovery from a financial crisis requires a restoration of the balance sheets of both financial and non-financial firms. The latter requires a well functioning bankruptcy law that enables balance sheets to be clean up so they can regain access to credit markets. Those insolvent institutions should close down and other healthy firms buy the assets of insolvent firms. Furthermore, owners of insolvent institutions should be punished because in any developing countries, they are provided with funds which enable the operation of their institution or to pocket substantial wealth. If they know that will be punished they do not keep their institution operating if it is insolvent. Thus will reduce the excessive risk and even further in reducing moral hazard.

Moreover encourage adequate prudential supervision. The moral hazard problem created by the existence of a safety net for financial institutions also can be limited by the usual elements of a well-functioning prudential regulatory/supervisory system: adequate disclosure requirements, adequate capital standards, prompt corrective action, careful monitoring of risk the institution’s risk management procedures and monitoring of financial institutions to enforce compliance with the regulations.

Another way for better operation is that we can engage operations only for countries that are truly willing to implement the necessary reforms. If a country reforms in accordance with the principles of the lender of last resort, that will make the effort from lender of last resort easier in times of financial crisis in such a country. Lastly, it is better for moral hazard problem, that lender of last resort operates only when it is absolutely necessary and for shorter periods of time.

The European lender of last resort?

Given that there is a need for a European lender of last resort, what institution would be the best to perform this roleTraditionally, central banks have acted as lenders of last resort because they have the advantage of being able to create the necessary liquidity. In addition, they have had experience with successfully performing this role. These facts would argue for the creation of a European central bank to act as a European lender of last resort. However, because it is highly unlikely that the major countries of theEuropewould be willing to give up control of monetary policy to a European organization to the future, creation of a European central bank is unrealistic.

The matter of the lender of last resort is a major concern in the construction of European Union. In spite of the existence of appropriate mechanisms to rescue distressed financial institutions in each country, the existing institutions do not allow for coordinate responses from different countries or a fast and efficient coordination between the European Central Bank (ECB) and the different national central banks.

The financial integration inEuropeis still low. In the recent past, however, multinational banking group have emerged (subsidiaries, mergers, acquisitions, branches) in Europe which provide wholesale services in more than one member state. These Pan-European banking groups play an active role on European money markets and provide liquidity to smaller banks in the interbank market. Also funds can shifted from one branch to another, so a liquidity shock in one money market will withdraw liquidity there and transfer funds for one market that is liquid. As a consequence, this leads to systemic implications as there is pressure in the latter market since local national central bank act as a lender of last resort. From the above anyone can choose any money market to withdraw funds, so here the question raised is which central bank act as a lender of last resort and on what terms. Without a European lender of last resort, the national central banks where these multinational banking parents groups are established and operated meets the liquidity needs of the whole group. This would bear the full credit risk. To handle a possible failure of such a pan-European banking group they established (Nordic countries) a structure for crisis management and agreed that in a crisis emergency liquid assistance will only be provided if the bank is not judged to be insolvent. Of course this kind of management, we cannot be sure that would be viable in the European Monetary Union. There is a need for a European lender of last resort function in case of failures of multinational banks. It may prevent too excessive interventionism by national central banks. The need of one European lender of last resort is necessary to control financial services of commercial banks, so the latter do not take higher risks and affect other commercial banks.

The ECB does not specify who is responsible for emergency liquid assistance in a financial crisis, it has delegated this to the national central banks but can intervene if is necessary. Of course this may cause delays in decision making, and this is one of the main principles of the role of lender of last resort, which is to act as soon as possible in financial crisis.

While the ECB can act as a European lender of last resort at any time, why it does not have a centralized lender of last resort or centralizes regulations yetOne possible answer is that the centralization of bank regulation and lender of last resort involves costs for national central banks as they lose flexibility in policy design. So the only reason that national central banks resign from these tasks the benefits should be higher than the costs. It is very difficult to achieve this goal because it has to be voted by the two thirds in the Governing council of ECB.

The only international organization that currently has the staff to acquire the necessary information to be the model for a similar creation of one European lender of last resort is the International Monetary Fund (IMF). However some reforms to function better as a lender of last resort is required. This is why, it has ended up engaging in this role during the recent crisis episodes. One objection to the IMF’s performing a lender of last resort role is that it cannot create unlimited liquidity as can a central bank. But it is not absolutely necessary that an international lender of last resort have unlimited resources to create liquidity, just that it has enough to do the job. Indeed, Fischer points out that under the gold standard, central banks in reality did not have an unlimited capability to create liquidity and yet were able to perform the lender of last resort role, and so the situation is not all that different.

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