Frameworks for Liquidity Support

Liquidity support is a key element of the financial sector safety net. Two somewhat dis­tinct functions—one operating at normal times and another in times of crisis—need to be identified. The first is the lender-of-last-resort (LOLR) function, which typically operates in the normal course of day-to-day monetary policy operations. Nearly all central banks have the authority to provide credit to temporarily illiquid, but still solvent, institutions. This kind of support can provide an important buffer against temporary disturbances in financial markets. LOLR actions may help to prevent liquidity shortages in one bank from being transmitted to other financial institutions, for example, through the payment system. LOLR actions are not intended to prevent bank failures but, rather, to prevent spillovers associated with liquidity shortages—particularly in money and interbank mar­kets—from interrupting the normal intermediation function of financial institutions and markets.

All central banks have a LOLR facility in place, but conditions and modalities are often not well defined.1 Ill-defined conditions may give rise to moral hazard and forbear­ance, with adverse consequences for the financial system. Thus, an important component in understanding the adequacy of the financial safety net is assessing the adequacy of the central bank’s operational procedures for LOLR support.

Somewhat distinct from the normal LOLR function is central bank emergency lend­ing. It is important for central banks to have procedures in place to provide emergency lending, with different modalities and conditions, in times of (imminent) crises. In cases of emergencies, a number of central banks have the legal authority to provide liquidity over and above what is allowed within the normal facility. Having those types of proce­dures available can be very useful to provide temporary support to the system in times of severe disruptions. However, the very existence of those procedures might lead to moral hazard in banks, causing them to hold less liquidity than they otherwise would do and to take other risks. As a result, the providing of emergency credit is typically at the discretion of the central bank (constructive ambiguity). Nonetheless, internal procedures and poli­cies—a form of contingency planning—should be in place for emergency lending, which should follow sound practices. In particular, the broad principles and the procedures gov­erning the decisions on emergency lending could be established and made transparent.

Key features of emergency lending procedures that should be considered include the following:2

• Resources should be made available only to banks that are considered solvent but are coping with liquidity problems that might endanger the entire system (e. g., too-big-to-fail cases).

• Lending should take place speedily.

• Lending should be short term; even then, it should be provided conservatively because the situation of a bank might deteriorate quickly.

• Lending should not take place at subsidized rates, but the rate also should not be penal because it might then deteriorate the bank’s position.

• The loan should be fully collateralized, and collateral should be valued conserva­tively. However, at times of severe crisis, it might be necessary for the central bank

to relax this criterion or to organize government guarantees or to arrange govern­ment credit, even if the loan is executed from the central bank’s balance sheet.

• Central bank supervisory authorities and the Ministry of Finance should be in close contact and should monitor the situation of the bank.

• Supervisory sanctions and remedial actions should be attached to the emergency lending.

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