The Reserve Bank as a lender of last resort

Reserve Bank Governor Glenn Stevens has spoken about the role of central banks as providers of liquidity and as lenders of last resort in times of crisis in this speech.

He defined "lender of last resort" as follows:

the role of lender of last resort [is] where the central bank lends to one specific entity, when no‑one else will. The first question is: why do we need it? The reason is the possibility – albeit a very remote one – that a panic could put overwhelming pressure on a perfectly sound institution that, though prudently managed, cannot possibly hold enough liquid assets to withstand the pressure unaided. Some entity has to be prepared to lend in such a situation if the market will not, otherwise the panic can imperil the institution concerned, and perhaps the financial system as well.

He summarised the general lessons from the recent events as follows:

One key lesson is the importance of liquidity in markets and to institutions, something that perhaps had not been emphasised as much as it should have been in regulation, where the emphasis has been very much on capital. We have further learned that, under conditions of great uncertainty, liquidity pressures can erupt in markets that had seldom been affected in the past. Central banks have responded quickly and flexibly to such events, but it has proven difficult to contain the pressures fully. Some quite important questions remain for the longer run, which central banks will be considering.

A second lesson is the difficulty in resolving a problem with an individual institution under strained overall conditions.  Bagehot’s formula provides only the most general of guidance; making it operational requires considerable judgement. If and when such an event comes, it tends to have its own unique elements and a particular set of circumstances as backdrop. Speed and flexibility in response are essential. So is consistent and early communication, since disclosure of support, if not managed very carefully, could turn out to make the situation worse rather than better.

A third lesson is that a loan of last resort is, in the end, probably simply bridging finance while a takeover or major re‑structure of the recipient institution is organised. The recipient would very likely see a change in its business model, management, board and ownership structure. It could well require a pretty clear statement of temporary government support. All of this would need to be organised very quickly.