Lender of Last Resort and Moral Hazard

The modern formulation of the lender of last resort (LOLR) was coined by Walter Bagehot in 1873. He argued that one of the main functions of a central bank was to maintain financial stability during times of market distress by providing emergency liquidity assistance in the form of loans to solvent but illiquid banks that are no longer able to refinance their operations on the markets. To limit moral hazard, central bank lending should be at a penalty interest rate and based on good collateral. In the 20th century, many central banks began to follow a policy of “constructive ambiguity,” thus suggesting that the LOLR would have the right to intervene in a crisis but would not promise in advance to do so. During the banking crisis of the 1980s and again during the global financial crisis (GFC) of 2007–2008, however, emergency lending to financial institutions was done at artificially low interest rates that did not reflect the credit risk of those institutions. These moves depart from the traditional principle established by Bagehot and mirror the strong interdependence between governments and central banks, on the one hand, and commercial banks, on the other. Following these crises, central banks have been following an alternative version of the LOLR principle in which lending to ailing institutions and markets would be automatically triggered if the values of bank and market assets fell significantly. This would prevent panics and avert a full-blown crisis. This chapter analyzes what types of moral hazard these evolving central bank practices have created and what they mean for the “lender of last resort” principle and the credibility of central banks as well as governments.