Great ideas don’t have time to look at a watch. So, they are sometimes ahead of their time.
The whole concept of “lender of last resort” originated at a time when many central banks were not even born. Many had ridiculed the concept at that time. But today the words of Walter Bagehot in his seminal work, Lombard Street, asking the central banks to lend “quickly, freely and readily” at penal interest rates sound like a home-made remedy. However, many still feel that such a role poses a “moral hazard”. Our friend Johnny is confused. He is trying to figure what role “the lender of last resort” plays.
Johnny: Last week you had told me that central banks play the role of lender of last resort. Tell me, under what circumstances do central banks assume such a role?
Jinny: There is no prize for guessing. Central banks assume this role only as a matter of last resort. Let’s try to understand what brings commercial banks at the doors of the lender of last resort. You may be aware that as a part of their business, banks accept money from their depositors. They keep a fraction of their deposits as reserves with the central bank and lend the remaining to their borrowers.
Banks work on the assumption that at any given point of time, only a fraction of depositors would turn up to take their money back. In normal times, the cash coming in as deposits every day and the reserves with the central bank are more than enough to take care of day-to-day repayments.
However, the bank may face a problem if a large number of depositors start asking for repayments at the same time.
In such a situation, the demand may exceed the cash in hand and the cash kept as reserves with the central bank. As you know, the rest of the money is lying with the bank’s borrowers. But the bank can’t go to its borrowers and ask for its money back. That’s because all loans given by your bank are repayable on maturity.
Borrowers are more comfortable than banks in the sense they can’t be forced to make repayment overnight. The loans given by your bank lie invested in plant, machinery and other goods that can’t be wound up overnight. In case borrowers are forced to make a repayment overnight, they will in all probability go bankrupt. So, your bank tries to explore another option.
Johnny: What could that be?
Jinny: Your bank borrows money from other banks for the short term. But this option can work only if other banks have confidence in your bank. In case other banks think your bank is on fire, they many decline to lend even a single penny. Nobody likes to jump into a fire.
Johnny: That’s true.
Jinny: At this stage, when all other doors are shut, the central bank assumes the role of lender of last resort. This is a purely discretionary role of the central bank and banks can’t ask for help as a matter of right. The central bank carries out this role in the larger interest of the financial market. Even sound and safe banks can sometimes experience difficulties in repayment due to immediate shortage of ready cash.
If your bank is unable to return the money of even a single depositor, there can be panic in the market. Panic begets more panic, and the queue of depositors outside your bank will get even longer. So, the shortage of cash, if not tackled immediately, can ultimately lead to the collapse of even a healthy bank. Liquidity problem of one bank may become liquidity problem of another bank. A simultaneous run on two or three banks is a sure-shot recipe for financial doom. So, it is necessary that the central bank assumes the role of lender of last resort by lending money to banks in trouble.
Johnny: I see. This means that the lender of last resort protects the larger interest of the financial market. But why do people talk about the “moral hazard” in such a role?
Jinny: It is very difficult to distinguish between a solvent bank and an insolvent bank facing shortage of money. Many times, banks face such problems when they are internally sick. If you have put your house on fire by recklessly lighting a firecracker, you have no moral right to ask for a fire tender. It is another matter if your house caught fire due to an accident not of your making. Using this logic, the proponents of moral hazard argue that central banks should not come to the rescue of insolvent banks. A broke bank must be left alone to face its day of reckoning. But despite all arguments, the central bank has to exercise its own judgement. Fire in one house, whether caused by pure recklessness or an accident, may well engulf the entire neighbourhood.
Johnny: Yeah, Jinny I agree. The central bank must be careful in exercising its judgement, otherwise financial markets may turn into “Bombard Street”.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org.