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Balancing lender of last resort assistance with avoidance of moral hazard

Goodhart, Charles (2017) Balancing lender of last resort assistance with avoidance of moral hazard. In: Heinemann, Frank, Klüh, Ulrich and Watzka, Sebastian, (eds.) Monetary Policy, Financial Crises, and the Macroeconomy: Festschrift for Gerhard Illing. Springer, Cham, Switzerland, pp. 19-26. ISBN 978-3-319-56260-5

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If an agent is certain to repay her debts, on time and meeting all the required terms and covenants, she can always borrow at current riskless market interest rates. So a liquidity problem almost always indicates deeper-lying solvency concerns. The solvency concerns that lenders may have about borrowers may, or may not, however, be well founded. I start in Section II by noting that the definition of solvency is fuzzy. The future likelihood of a borrower defaulting is probabilistic, and so the terms (the risk premia) and conditions on which a borrower can raise cash, her access to liquidity, are stochastic and time varying, Section III. There is a common view that a Central Bank should restrict its activities in support of financial market stability to lending into the general market via open market activities, rather than lending to individual banks via Lender of Last Resort (LOLR) measures. I explain why I disagree with that argument in Section IV. Nevertheless the banks most in need of LOLR will generally be those that have been least prudent. Even though the Central Bank will choose not to support the most egregiously badly-behaved (and/or those whose failure is least likely to generate secondary contagious-failures), the use of LOLR does entail a degree of insurance (against failure) and hence generates moral hazard. I discuss in Section V various ways of mitigating such moral hazard.

Item Type: Book Section
Official URL:
Additional Information: © 2017 Springer International Publishing AG
Divisions: Financial Markets Group
Subjects: H Social Sciences > HG Finance
H Social Sciences > HJ Public Finance
Date Deposited: 28 Nov 2017 15:19
Last Modified: 20 Oct 2021 00:15

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