After the Financial Crisis
Elgar original reference
Edited by Sylvester Eijffinger and Donato Masciandaro
Chapter 4: The Lender of Last Resort: Liquidity Provision versus the Possibility of Bailout
Rob Nijskens and Sylvester Eijffinger Introduction The financial crisis of the last two years has shown that banking regulation is not adequate to safeguard the stability of the financial system. While prudential regulation (such as the Basel II capital requirements) has allowed for regulatory arbitrage, the existence of a lender of last resort has been insufficient to deter banks from taking risks that are harmful to the financial system. Furthermore, (ex post) policies for crisis management have not been able to resolve the crisis in a clean way. In 2008 and 2009, central banks around the world have had to provide substantial amounts of liquidity to alleviate liquidity shortages and to prevent the interbank market from breaking down completely. They have provided this liquidity on very generous terms, letting virtually every bank access their facilities. Among the many banks that received liquidity assistance, several were in fact insolvent. This goes against the principle advocated by Bagehot (1873): insolvent banks should not be provided with liquidity. However, as these banks constitute a risk for the financial system as a whole, regulators have had no choice but to save them. This suggests that the Too-Big-to-Fail problem still exists, although many now call it a Too-Connected-toFail problem. This means that the interlinkages between banks are so dense that contagion of bank failures has become inevitable (Nijskens and Wagner, 2011). In addition to the liquidity provision by central banks, governments around the world have constructed very large rescue packages to restore confidence in the...
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