(IDEI, Toulouse University, France) THE LENDER OF LAST RESORT Jean-Charles ROCHET (IDEI, Toulouse University, France) Prepared for the conference “Banking Crisis Resolution-Theory and Policy” organized by the Bank of Norway, Oslo June 16-17th 2005

Impressive number of banking (and financial) crises in the last INTRODUCTION Impressive number of banking (and financial) crises in the last 30 years: Among IMF member countries: approximately 130 out of 180 have experienced crises or serious banking problems Cost of Savings and Loans debacle in the USA (late 1980s) > loss of all failed US banks during Great Depression (Calomiris, 1999) Average cost of recent banking crises per country: ~ 12 % GDP (but more than 40 % in some cases: Argentina, Indonesia, Korea, Malaysia).

Banking crisis No significant banking problems/Insufficient information Significant banking problems

Renewed interest of economic research on: The causes of fragility of banks The justifications and organization of public intervention, which can take several different forms: emergency liquidity assistance by the central bank closure rules and solvency requirements deposit insurance interest rate controls. Although the different aspects of public intervention are intrinsically connected, I will focus on the first point (my assignment today) the lender of last resort

1 The classical doctrine First part: survey of the theory and the practice 1 The classical doctrine Thornton (1802) Bagehot (1873) a) lend only against good collateral (Solvent banks) b) lend at a penalty rate (Illiquid banks) c) announce readiness to lend without limits (Credibility) After the panic that followed the Overend - Gurney failure (1866), LLR operations became standard practice, first in the UK (Barings crisis, 1890) then in continental Europe.

Bordo (1990) provides historical evidence of the use of LLR functions as a way to mitigate banking crises. Timberlake (1984) shows that US private clearing houses played a LLR role during the national banking era (1857-1907), before the creation of the FED and the discount window (1913) Calomiris (1999), among many others, questions the role of the IMF as an international LLR.

2- The Practice: Several Examples Bank of New York, November 21st, 1985 Computer bug in the bank’s T- Bills clearing system emergency loan of $ 22.6 billion by the FED: too much for a single bank, too fast for a consortium. Closure of a large bank, followed by Emergency Liquidity Assistance(ELA) offered to other banks: Herstatt bank, 1974 (German Bundesbank), Barings, 1995 (Bank Of England). Intervention to prevent market crashes commercial paper run after Penn Central Bankruptcy in June 1970 (Calomiris 1994) Russian bonds default and LTCM crisis in September- November 1998 (Edwards, 1999; Furfine 2000)

Secondary Banking crisis in 1973-75 (Bank Of England) Violations of a): Rescue of Yamaichi Securities, 1965 (Bank Of Japan.) Secondary Banking crisis in 1973-75 (Bank Of England) Difficulty to separate the LLR policy from banking supervision and closure policy. Several well known examples of insolvent banks that were bailed out either for purely political reasons: Crédit Lyonnais (1992-96, France), or on contagion grounds: Continental Illinois (1984, USA), (Johnson-Matthey, 1984, UK).

In fact, empirical evidence on the resolution of bank defaults suggests that failing banks are more often rescued than liquidated. Goodhart and Schoenmaker (1995): effective methods of resolving banking problems vary a lot from country to country but in most cases result in bail outs Out of a sample of 104 failing banks they find that 73 resulted in rescue and 31 in liquidation Santomero and Hoffman (1998): in the USA, the discount window was often used (improperly) to rescue banks that subsequently failed

3- Criticisms to the Classical Doctrine Goodhart (1985): Impossibility of clearly drawing a line between illiquid and insolvent banks. Solow (1982): Central Bank also responsible for stability of the financial system  sometimes rescue insolvent banks  moral hazard Kaufman (1991): Public intervention subject to political pressure and regulatory capture. Discount window = disguised means to bail out insolvent banks.

risk and banks’ moral hazard. Goodhart - Huang (1999a): Trade-off between contagion risk and banks’ moral hazard.  Rescue insolvent banks above a certain size (Too Big To Fail) + random intervention (Constructive Ambiguity). Freixas (1999): Make intervention conditional on the amount of uninsured debt issued by the distressed bank. Constructive ambiguity limits moral hazard.

(aggregate liquidity) Goodfriend and King (1988) Banking Policy (interventions on individual banks) Monetary Policy (aggregate liquidity) Argue that with modern inter-bank markets, banking policy has become redundant. “A solvent bank cannot be illiquid” LLR could be replaced by private Lines-Of-Credit services (Goodfriend-Lacker, 1999)

Second Part: a synthesis of current academic views and policy recommendations 1-Why do we need a LLR? Even modern inter-bank markets may not be sufficient to provide liquidity assistance to banks in trouble. There are several reasons for that: Externalities and contagion risk in Large Value Payment Systems (Freixas et al.2000). The failure of a large bank may propagate to other banks. Possible coordination failures on inter-bank markets (Rochet-Vives 2004). Fire-sales premiums or “haircuts” create strategic complementarities on inter-bank markets. Wholesale investors may refuse to lend to a bank not because they think it is insolvent (“fundamental risk”) but because they think other investors will refuse to do so (“strategic risk”). Solvent banks may be illiquid

1-Why do we need a LLR? (continued) Other circumstances in which liquidity provision by inter-bank markets may be insufficient: Contagion generated by market incompleteness (Allen-Gale 1998) Orderly resolution of failures Macroeconomic shocks Academic literature has focused on micro-prudential regulation (how to deal with financial distress of individual banks) But public authorities are also concerned by overall financial stability (macro-prudential regulation)

2-How to organize emergency liquidity assistance? For micro prudential purposes, liquidity shocks can be managed optimally by an ex-ante liquidity requirement and a system of multilateral credit lines commitments between banks. If liquidity shocks have a common component (macro shock), the CB is needed as a LLR and its collaboration between the FSA, the DIF and the Treasury has to be carefully designed.

MY MAIN MESSAGE TODAY: deposit insurance and capital requirements are not enough regulatory/supervisory systems should be reformed, so as to deal properly not only with individual bank failures (micro- prudential regulation) but also with systemic crises( macro-prudential regulation)

MY MAIN MESSAGE TODAY (2): Central bank independence for monetary policy should be extended to lender of last resort activities Liquidity assistance to the banks in trouble should be provided under the strict control of independent supervisory authorities

Deposits insured by Deposit Insurance Fund (DIF) for a premium P . 3 A MODEL OF PRUDENTIAL REGULATION Rochet (2004) Adaptation to the banking sector of Holmström-Tirole (1998)(model of corporate financing) 2 dates t = 0,1; bank lends volume L of loans, financed by deposits D and equity E. Interest rate normalized to zero. Deposits insured by Deposit Insurance Fund (DIF) for a premium P . Macro-shock: additional liquidity need at t = 1/2 E t=0 t=1/2 Shock? t=1 Moral Hazard continue Success Stop Failure Lending D Crucial question: which banks allowed to continue (x=1) and which banks are closed (x=0) in the event of a shock at date t = 1/2 ?

Optimal prudential organization in the absence of macro-shocks There are 2 equivalent solutions: Public authority: regulates banks’capital and DIF premiums Banking supervisors close banks that do not comply with capital requirements Private contracting between competing DIFs and the banker: deposits limited to a certain multiple of banks’capital insurance premiums set by competition between DIFs. NB: problem of private DIFs: do not resist in front of systemic shocks

separation of banks into two categories: Optimal regulation in the presence of macroeconomic shocks: separation of banks into two categories: · Banks such that (small exposure to macro shocks) should not be closed in case of macro shock at t=1/2, but should be subject to a higher capital ratio (than in the absence of macro shocks) · The banks such that (large exposure to macro shocks) should be closed if a recession occurs and should be subject to a flat capital ratio

Implementation: different roles of private investors and regulators Private investors only interested by future cash flows: Only refinance solvent banks (too many closures) Public regulators subject to political pressure (efficient lobbying) Also refinance banks that should be closed (too few closures). Public intervention is needed to avoid too many bank closures but it may lead to forbearance and overinvestment

4- POLICY RECOMMENDATIONS Two elements are needed for implementation of the optimal allocation: ·Intervention of the central bank as a lender of last resort for providing liquidity assistance ( in case of a recession) to the banks characterized by low macro exposure. ·Preventing extension of this liquidity assistance to other banks, with higher macro exposure. For these banks ex post continuation value is positive (from a social point of view) but bailing them out would be welfare decreasing from an ex-ante perspective.

The optimal way to manage emergency provision of liquidity to banks can be obtained by the following organization of the regulatory system: · for each commercial bank, supervisory authorities evaluate the bank's exposure to macroeconomic shocks ·Banks with a small exposure are backed by the DIF and receive liquidity assistance by the Central Bank in case of a macro shock. They face a capital adequacy requirement and a deposit insurance premium that increase with macro exposure

· Banks with a large exposure to macro-shocks are not backed by the DIF: they should not receive liquidity assistance by the Central Bank. · They face a flat capital requirement and a flat deposit insurance premium · The lender of last resort activities of the central bank are made independent from political powers: the central bank only provides liquidity assistance to the banks that are backed by supervisory authorities.

CONCLUSIONS (1): The main reason behind the frequency and magnitude of recent banking crises is not deposit insurance, bad regulation, or incompetence of supervisors. It is the commitment problem of political authorities, who are likely to exert pressure for bailing out insolvent banks and delay crisis resolution. The remedy to political pressure on banks supervisors is not to substitute supervision by market discipline: market discipline can only be effective if absence of government intervention is anticipated.

CONCLUSIONS (2):. Instead the way to restore credibility is to ensure independence and accountability of bank supervisors The other key reform is to restrict liquidity assistance by the central bank to the banks with low exposure to macro shocks, that are backed by the independent supervisors (alternative: cap on macro exposure). Supervisors should be in charge of selecting these banks, who then would face a capital requirement and a deposit insurance premium that both increase with their macro exposure

CONCLUSIONS (3): By contrast, banks with a too high macro exposure should not be backed by the supervisors and should not receive liquidity assistance in case of macro shocks Central bank loans should be insured by the DIF.