Question

b) Discuss to what extent lender of last resort and deposit insurance can serve as destabilizers to the banking system. What are the measures that can be applied to address instabilities? (10 marks)

Answer 1

Usually, the central bank of the country is the lender of last resort to the banks in that country. Take for instance the Fed in the US. Take for example the impact of Coronavirus in banks. The central banks are infusing liquidity into the banks by doing TLTRO (targeted long term repo operations) ie providing cash against the government securities the banks are holding at very low-interest rates to reduce their interest costs. The central banks are also providing with unsecured overnight borrowings at very low-interest rates which otherwise would not have been possible. The central banks in some countries, apart from buying the government securities, are also buying bonds issued by corporates that otherwise are illiquid in the current scenario and will sell at a sharp discount. The central banks are taking all these initiatives just to ensure that banks are able to service their liabilities in time.

The central banks by doing do so make banks more reliant on the central banks to help them in stressful times rather than relying on their internal risk management systems or equity investors to pump in money in times of stress.

The banking business is itself a risky taking business. Depositors put their money in banks to earn interest on deposits which usually are higher than the risk-free rate (overnight indexed swaps). With a higher interest on deposits comes a higher risk, which the depositors usually ignore, because they feel their deposits are safe and risk-free. This assumption is based on the assurance given by central banks who contemplate that they shall not allow the banking system in the country to fail, which sometimes makes management of the banks act recklessly.

Measures that can be used are (a) enforcement of stronger risk management practices such as the implementation of Basel iv guidelines with lesser leeway given to banks in deciding over the risk capital (b) lesser bailout packages to banks to curb moral hazard the management of banks does to inflate profits