Central Banks Should Be Reluctant to Act as a Lender of Last Resort

Topics: Monetary policy, Central bank, Bank Pages: 6 (2155 words) Published: June 16, 2013
Topic 2: Discuss the extent to which a National Central Bank should be reluctant to act as a lender of last resort.

This study provides an overview of central bank’ “lender of last resort” (LOLR) function. “Lender of last resort” has a very important role in helping the central bank’s monetary policy operating through changes in rediscount rate and refinance rate. The main purpose of LOLR for all the central banks is to ensure the stability and safety of the commercial banking system. In this paper, I will define central bank and its function. Next, I will evaluate why central banks should be reluctant to act as a lender of last resort.

I. Introduction

Central bank is a public institution that manages a state’s currency, money supply, and interest rates. Central banks have a wide range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment. Central banks also generally issue currency, function as the bank of the government, regulate the credit system, oversee commercial banks, manage exchange reserves and act as a lender of last resort. However, the role of Central Bank and the scope of its participation may change due to the effect of different laws and the presence of various stakeholders. Thus, US Central Bank does not act as a regulatory body of the financial sector (Driffill et al., 2005), while the intervention activity of Japan Central Bank demand the approval of other governmental bodies (Fujiwara, 2005). The role of central banks becomes more important in the financial crisis that originated in the United States in summer 2007. Its breadth and potency rapidly increased, spilled over into the global financial system after the collapse of Lehman Brothers in the autumn of 2008. According to Hiroshi Nakaso, the crisis again reminded us of the inherent instability of the financial system and the vicious compounding of problems between the financial system and the real economy. In response, central banks around the world took action, including cuts in interest rates, the provision of ample liquidity, and so-called nontraditional or unconventional measures. Among these, the “lender of last resort” (LLR hereafter) function was the most critical that was carried out by central banks amidst the deepening crisis (Hiroshi Nakaso, 2013). However, in the current market environment, is LLR effective? That will be followed by a discussion of a few issues pertaining to the central bank’s LLR function. This study tried to determine that central banks should be reluctant to act as a lender of last resort. The remainder of the paper is set out in four sections. In the next section the central bank and its function is reviewed. In the following section, the reason why central bank should limit LLR activities is evaluated. And the final section concludes.

II. The role of central bank

Central banks, acting on behalf of or independently from their governments, can exert over interest rates. The ability of all central banks to exercise any influence over interest rates lies in their role as lenders of last resort. This in turn relies upon their role as monopoly suppliers of liquidity in the event of a general shortage of funds. No commercial bank or credit institution would dare to assert that in the history of their activities did not have a moment that they were stuck in cash. The massive cash withdrawal (due to low interest rates, high inflation, so the interest rate becomes negative, as can other types of investments have a higher benefit or because there is not enough confidence in banks, etc.) will be easy to make banks insolvent and do not have enough cash to pay for the people. In such cases the commercial banks are no longer lending else, can not recover the loan in time, it would have to the central bank for a loan as a last resort. Chandavarkar (1996 quoted in Geraats, 2002) claims that...

References: 1. Driffill, J., Rotondi, Z., Savona, P. and Zazzara, P. (2003) Monetary policy and financial stability: What role for the futures market?, Journal of Financial Stability, March.
2. Fujiwara, I. (2005) Is the central bank’s publication of economic forecasts influential? Economic Letters, Vol. 89,
3. Geraats, P. M. (2002) Central Bank Transparency, The Economic Journal, Vol. 112
4. Beine, M., & Bernal, O. (2005) Why do central banks intervene secretly? Preliminary evidence from the BoJ. Journal of International Financial Markets, Institutions and Money.
5. Borchgrevink, H. & Moe, T.G. (2004) Management of financial crises in cross-border banks. Economic Bulletin 4/04, Norges Bank.
6. Gerdrup, K.R. (2005) Norges Bank’s role in the event of liquidity crises in the financial sector. Economic Bulletin
7. Hiroshi Nakaso (2013) Financial crises and central banks’ “Lender of Last
Resort” function, the Executive Forum “Impact of the financial crises on central bank functions”, hosted by the World Bank, Washington DC, 22 April 2013.
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