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. | MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Session: TWENTY THREE 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 2 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 market LOLR policy as part of the banking safety net Lessons for the LOLR’s role Case Example: The State Bank of Pakistan 3 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. 4 Lender of Last Resort (Contd.) This means that the central bank is the . | MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING SUPERVISION OSMAN BIN SAIF Session: TWENTY THREE 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 2 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 market LOLR policy as part of the banking safety net Lessons for the LOLR’s role Case Example: The State Bank of Pakistan 3 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. 4 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 next due to a lack of liquidity. 5 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. 6 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. 7 Classical Theory
