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P2.T9.602. Liquidity regulation and lender of last resort

Nicole Seaman

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Learning objectives: Compare the advantages and disadvantages of liquidity regulations and a lender of last resort in managing liquidity and systemic risk during a financial crisis, and identify situations where each is more effective. Explain how the existence of a lender of last resort can create moral hazard. Describe situations where a central bank should begin lending to banks before liquidity buffers are exhausted. Describe challenges and constraints to a central bank acting as a lender of last resort. Analyze the Federal Reserve’s lending policies and lending decisions during the 2007-2009 financial crisis, and describe the effectiveness of each. Explain how a combination of liquidity regulations and lender of last resort can lead to an optimal policy mix to manage systemic risk during financial downturns

Questions:

602.1. According to the Federal Reserve Board (Carlson, Duygan-Bump and Nelson), one motivation for regulatory changes after the 2007-09 financial crisis was the potential costs associated with moral hazard. Specifically, "Part of the motivation for these regulatory and legal changes was the view that central banklending was itself a bad thing—that the loans were bailouts of financial institutions that protected them from the consequences of their risky behavior. Within the economic literature, moral hazard is seen as the principle cost associated with central bank lending as it encourages institutions to take on more risk than they would otherwise. Some have also criticized this lending on the grounds that it pushed central bank policy into fiscal policy and threatened the independence of the Federal Reserve. These concerns have led to proposals by some to eliminate even the remaining emergency authority of the Federal Reserve to lend in unusual and exigent circumstances."

According to the authors, which of the following statements is MOST ACCURATE about moral hazard cost(s) engendered by the central bank in its role as lender of last resort (LOLR)?

a. LOLR does not create significant moral hazard costs if communication by the central bank is clear and effective
b. LOLR DOES incur significant moral hazard costs when liquidity demands are associated with broad-based run-like situations on solvent institutions (i.e., exogenous market stress), however LOLR does NOT create moral hazard costs when associated with creditor concerns over the solvency of an institution(s)
c. LOLR does NOT incur moral hazard costs when liquidity demands are associated with broad-based run-like situations on solvent institutions (i.e., exogenous market stress), however LOLR DOES incur significant moral hazard costs when associated with creditor concerns over the solvency of an institution(s)
d. Unfortunately, LOLR almost always creates significant moral hazard costs


602.2. During the financial crisis, two of the most prominent examples of Federal Reserve lending in response to troubles at individual institutions were Bear Sterns and American International Group (AIG). Each of the following is true about Bear Sterns and AIG EXCEPT which is false?

a. In the end, both of the loans to Bear Sterns and AIG were repaid in full with interest
b. In both situations, the Federal Reserve as lender of last resort (LOLR) was the best solution given that neither liquidity regulations nor a resolution authority could have facilitated a better outcome
c. In both situations, the Federal Reserve had no supervisory authority of the institutions (ie, AIG and Bear Sterns) and consequently did not have examiners familiar with their operations;
d. In both situations, the Federal Reserve made requick and non-recourse loans, looking exclusively the uncertain value of the collateral to protect itself from losses


602.3. According to the Federal Reserve Board, which of the following statements is TRUE about the policy implications with respect the liquidity regulations and the Fed's role as lender of last resort (LOLR)?

a. Liquidity regulations can be sufficient substitute for a lender of last resort (LOLR) policy conditional on high liquidity buffer requirements
b. Lending aggressively by the LOLR during times of systemic shocks is a key element of optimal policy to help limit pressures to hoard liquidity and break the procycliality of liquidity crises
c. Liquidity regulation should stand "in front of" the LOLR: in almost all cases, a financial institution should first run down its liquidity reserves and then it should borrow from the LOLR who should wait for the institution to first run down their liquidity buffer
d. Given the consequences demonstrated by the Fed's role as LOLR in Lehman Brothers and its support contributed to the evidence that the Fed's role as LOLR is rife with moral hazard costs, the Fed should almost never assume the role of LOLR

Answers here:
 
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