The following will be discussed in this chapter: Lender of last resort, classical theory, LOLR and bank closure policy solvent banks and insolvent banks, systemic risk contagion, liquidity in a non functioning interbank market, LOLR policy as part of the banking safety net.
Session: TWENTY THREE MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Summary of previous Session • Corrective actions for weak Banks • General principles for corrective action • Guiding principles for banks resolution policy • Resolution techniques • Conclusion: Dealing with Weak Banks Summary of this session • Lender of Last Resort • Classical Theory • LOLR and Bank closure Policy • Solvent banks and Insolvent Banks; LOLR • Systemic Risk • Contagion • Panic of 2008 crisis • Liquidity in a non functioning interbank Lender of Last Resort • The discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source Lender of Last Resort (Contd.) • • • This means that the central bank is the lender (provider of liquidity) of last resort (if there is no other way to increase the supply of liquidity when there is a lack thereof) The function has been performed by many central banks since the beginning of the 20th century The goal is to prevent financial panics and bank runs spreading from one bank to the Lender of Last Resort (Contd.) • • Since the creation of the first central banks in the 19th century, the existence of a lender of last resort (LOLR) has been a key issue for the structure of the banking industry Banks finance opaque assets with a long maturity with short-lived liabilities – a combination that is vulnerable to sudden loss of confidence Classical Theory • To avoid avoidable disasters when confidence evaporates, the classical view (Thornton 1802 and Bagehot 1873) is that the central bank should lend to illiquid but solvent banks, at a penalty rate, and against collateral deemed to be good under normal times Classical Theory (Contd.) • • With the development of well-functioning financial markets, this view has been considered obsolete Goodfriend and King (1988) in particular argue that the central bank should just provide liquidity to the market and leave to banks the task of allocating credit and monitoring debtors Classical Theory (Contd.) • • • On account of extensive research by both Thornton’s and Bagehot’s works, their main proposals are as follows: (1) protect the money stock instead of saving individual institutions; (2) rescue solvent institutions only; Classical Theory (Contd.) • (3) let insolvent institutions default; • (4) charge penalty rates; • (5) require good collateral; and 10 Lessons for the LOLR’s role (Contd.) • • Fourth, regulators around the world have a mandate to protect the interests of their national investors The international coordination of regulators, and in particular, the European coordination has been helpless when faced with the real cost of the Icelandic crisis 37 Case Example: The State Bank of Pakistan • • The State Bank of Pakistan is the lender of last resort for the Pakistani commercial banks It at any time the banks are short of cash reserves, the State Bank of Pakistan comes to their rescue 38 Case Example: The State Bank of Pakistan (Contd.) • • It provides cash to commercial banks by rediscounting bills of exchange and treasury bills The State Bank of Pakistan thus helps and maintain liquidity ad solvency of the commercial banks 39 Principal role and Objective of SBP • • A principal role of SBP is to provide liquidity to the banking system in times of systemic illiquidity problems SBP’s principal objective as LOLR is to maintain liquidity in the banking system as a whole and ensure the smooth functioning of the payments system 40 Principal role and Objective of SBP (Contd.) • • • Another objective is to ensure that solvent banks not fail due to temporary illiquidity At present, SBP provides liquidity for solvent banks facing temporary liquidity problems using different instruments With its off-site monitoring mechanisms and on-site inspections of banks SBP has a good idea of banks’ solvency situation 41 SBP ACT • • • The SBP Act must be changed to better specify SBP‟s role and powers as LOLR Under existing law the SBP has very limited scope to function as LOLR: the SBP Act calls for all lending to be secured SBP can provide liquidity to the overall market but has limited capacity for providing liquidity to individual banks Once individual banks have run out of un42 encumbered government securities, SBP SBP ACT • When a bank runs out of collateral and becomes illiquid, SBP would need to close it Recent liquidity problems in the market have tested SBP’s ability to manage the stress situation, which SBP has managed successfully through its monetary tools 43 SBP ACT (Contd.) • The SBP needs broader legal authority to deal with illiquid banks The law should define what institutions are eligible for SBP support, including guarantees of different kinds, and what assets qualify as collateral 44 SBP ACT (Contd.) • • It is proposed that only scheduled banks, including branches of foreign banks, be eligible counterparts for LOLR support and that all NBFIs be excluded from access All support should be short-term 45 Internal Rules and Criteria • • • SBP has developed a set of internal rules and criteria, which helps it make consistent decisions and better justify its actions and facilitate accountability afterwards It should seek to make its decisions consistent both among classes of banks and over time New LOLR operating rules distinguish 46 between bank-specific and systemic Internal Rules and Criteria (Contd.) • • These rules are based on different policy scenarios but also leave sufficient room for tweaking and policy changes in view of different economic and financial realities of each situation SBP has sought legal powers to make all LOLR support conditional on corrective actions by the borrowing bank 47 Internal Rules and Criteria (Contd.) • • • LOLR policies and rules are closely coordinated with bank exit policies LOLR rules are for internal use and it will be up to the SBP to determine what general rules and criteria it may wish to make transparent Details of corrective actions by individual banks using LOLR facilities will remain confidential 48 Internal Rules and Criteria (Contd.) • Unsecured LOLR lending would have to be guaranteed by the government Such lending should be considered potential solvency support, and take-over of the institution for an eventual resolution strategy 49 Summary of this session • Lender of Last Resort • Classical Theory • LOLR and Bank closure Policy • Solvent banks and Insolvent Banks; LOLR • Systemic Risk • Contagion • Panic of 2008 crisis • 50 Liquidity in a non functioning interbank THANK YOU 51 ... contagion (Allen and Gale 2000 and Freixas, Parigi and Rochet 2000) 17 The panic of 2008 and subprime crisis of 2007 • The panic of 2008, originating with the subprime crisis of 2007, offers key insights... systemic risk and illustrates vividly the new role of a lender of last resort 18 The panic of 2008 and subprime crisis of 2007 (Contd.) • Years of accommodating monetary policy, regulatory arbitrage... The panic of 2008 and subprime crisis of 2007 (Contd.) • The opacity of the assets of the banks and of the financial vehicles they created to hold mortgages resulted in a dramatic and sudden