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Why do central banks provide liquidity as lender of last resort?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • May 13, 2020
  • 5 min read

Updated: Aug 13


US Dollar banknotes

Central banks absorbed COVID-19 shocks through lender of last resort programs.


Liquidity risk is intrinsic to banking due to the maturity mismatch between short-term deposits and long-term loans, which is essential for funding investments that create jobs and support economic growth.


Central banks act as lenders of last resort (LOLR) to prevent systemic collapse by providing emergency liquidity when normal markets freeze.

Past crises like 2008 and the COVID-19 pandemic demonstrated the importance of flexible LOLR tools, including accepting a wide range of collateral and extending liquidity to non-bank financial institutions.

While concerns exist that LOLR access could encourage risky behavior, strong capital and liquidity regulations help deter misuse. Ultimately, the LOLR function is vital to maintain financial stability, ensuring that liquidity shortages do not escalate into full-blown economic crises.


The Nature of Liquidity Risk in Banking


Liquidity risk is an inherent feature of the banking sector due to maturity transformation — the process whereby banks convert short-term deposits into long-term loans. This function is vital for funding investments that create jobs and economic growth. Without banks bearing this liquidity risk, many productive investments would remain unfunded, resulting in reduced employment and societal welfare.


Banks act as intermediaries earning the margin between deposit and credit rates, and even without maturity transformation, they could still generate profits through short-term lending. However, liquidity risk remains fundamental because crises can cause even the best-managed banks to fail when faced with mass withdrawals. The interconnected financial system means one institution's failure can trigger widespread liquidity shortages and defaults.


Financial Crises and Systemic Vulnerabilities


In times of financial turmoil, it is difficult to distinguish between solvent and insolvent institutions, as liquidity shortages can render sound banks temporarily insolvent. Consequently, crises are not the right moments to remove “bad apples” but rather to ensure liquidity support. Regulatory measures like increased capital and liquidity requirements are better suited to normal periods to build resilience.


Bank failures can trigger domino effects akin to avalanches, where one institution's inability to meet obligations causes counterparties to suffer liquidity shortfalls, leading to mass asset liquidations and plummeting collateral prices. This cascade results in job losses, wealth destruction, and economic downturns on a broad scale. Tightening lending conditions during crises exacerbates these dynamics, as rising margin calls and collateral demands deepen financial stress.


What is lender of last resort (LOLR)?


A lender of last resort is typically a central bank that provides emergency liquidity to solvent but illiquid financial institutions or markets during times of acute financial stress, when normal sources of funding have dried up (Freixas et al., 2000). Its role is to prevent liquidity crises from escalating into solvency crises that can destabilize the entire financial system.


The classical framework, articulated by Walter Bagehot in Lombard Street (1873), holds that a LOLR should “lend freely, at a high rate, against good collateral” to contain panic while limiting moral hazard. Modern practice has broadened this scope to include non-bank intermediaries and key financial markets, as seen in the U.S. Federal Reserve’s interventions during the 2008 global financial crisis and the 2020 COVID-19 shock (Allen et al., 2020).


By supplying liquidity in emergencies, the LOLR safeguards the payment system, preserves financial intermediation, and upholds public confidence in the stability of the monetary and banking system.


Implementations of Lender of Last Resort Mechanisms in Major Economies


United States


The Federal Reserve is widely recognized for its robust and flexible LOLR framework. Beyond traditional discount window lending, the Fed expanded liquidity facilities during crises to include the Term Auction Facility (TAF) in 2007–2008 and multiple special purpose vehicles (SPVs) during COVID-19, such as the Primary Dealer Credit Facility (PDCF) and Commercial Paper Funding Facility (CPFF). These tools broadened access beyond banks to nonbank financial entities and commercial paper markets, ensuring systemic liquidity (Federal Reserve Bank of New York, 2020).


European Union


The European Central Bank (ECB) has adapted its collateral framework extensively, accepting a broad range of securities including asset-backed securities and corporate bonds during crises. Its Pandemic Emergency Purchase Programme (PEPP) during COVID-19 injected liquidity and eased financing conditions across eurozone countries, balancing differing national fiscal conditions while maintaining financial stability (ECB, 2020). Unlike the Fed, the ECB must negotiate among diverse national interests, which sometimes slows unified action.


United Kingdom


The Bank of England expanded its LOLR operations in 2008 by extending facilities such as the Special Liquidity Scheme, swapping illiquid mortgage assets for Treasury bills, and implemented asset purchase programs (quantitative easing) to support liquidity. During COVID-19, the BoE increased the scale of its sterling repo operations and broadened eligible collateral to support the financial system (BoE, 2020).


Japan


The Bank of Japan (BoJ) has maintained a longstanding role as LOLR, providing ample liquidity through various facilities. During the global financial crisis and the pandemic, the BoJ enhanced repo operations and asset purchase programs, focusing on maintaining market functioning amid deflationary pressures (BoJ, 2021).


The Role and Importance of the Lender of Last Resort


The financial sector functions as the critical mechanism for transforming savings into productive investments. Interruptions to this process can stifle job creation and economic expansion, necessitating strict regulation of financial institutions.


When preventive regulations fail, the lender of last resort (LOLR) becomes essential for stabilizing the system. By supplying liquidity during panics, central banks prevent runs and contagion. Although concerns exist that LOLR access might encourage reckless behavior during normal times (Goodhart, 2017), stringent capital and liquidity rules mitigate such risks.

Central banks’ crisis policies—including broadening accepted collateral and extending liquidity support to all significant financial actors regardless of legal form—are crucial for averting financial system collapse and limiting contagion effects.


References


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