The European Central Bank has acted as a lender of last resort (LOLR) during the crisis. It has lend freely and without limit. Many commentators have applauded this policy, and today you do not find much discussion on it. However, in these times there are no no-brainers. Let me bring up the excellent Willem Buiter:
The Bagehotian LOLR intervenes for two reasons.
(i) Bank runs are unnecessary. Typically, the formal models of bank runs show that there exist (at least) two equilibria: one in which there is no bank run and at one in which there is no bank run. Without a central bank acting as LOLR (or some other device like compulsory bank holidays, in which the sequential service constraint (the first-come, first-served right of depositors to withdraw their money) is suspended), there can be a ‘coordination failure’ causing depositors to focus on the wrong equilibrium, the ‘run’. The LOLR eliminates the run equilibrium.
(ii) Bank runs are costly. They may cause banks to go bankrupt; they may impair the payment system (whencheckable bank deposits are an important means of payment) and they may interfere with the ability of the banking system to extend new loans or roll over existing ones, thus impairing the supply of trade credit, working capital etc. etc. Bankruptcy is socially costly. It is not just a reshuffling of ownership claims. Real resources are wasted on lawyers, auditors, accountants and bailiffs. ‘Going concern value’, including goodwill may be destroyed. Established relationships between borrowers and loan officers may be interrupted and social capital diminished.
Let me add one more thing: a central bank should only go into LOLR mode if there is a liquidity crisis. A liquidity crisis is a situation where financial institutions are fundamentally sound, but find it difficult to roll over existing debt because of adverse conditions in the financial markets.
A completely different situation is that of an insolvency crisis. Here, financial institutions are bankrupt because of lending to borrowers who cannot repay, or buying assets that turn out to be non-performing to a large extent. The policy conclusions of these two cases, as you might already understand, are not the same: whereas in a liquidity crisis LOLR is the right policy, it is not in an insolvency crisis. Bankrupt financial institutions should be allowed to fail in order to distribute the losses to those responsible.
Sadly, the European institutions have agreed to rule the financial crisis a liquidity/public debt crisis. It is, however, clearly an insolvency/private debt crisis. European banks have invested in toxic assets (mostly mortgage-related) and, when faced with the consequences, went into bankruptcy territory. They were then bailed out by the public. Now the public – via the ECB – holds some of the toxic assets, which seem to generate heavy losses. This is the story behind the ECB capital boost from this week. (By the way: 2,5 years ago Willem Buiter was ridiculed for asking “Can central banks go bust?“. It seems now that Europe might turn into another Iceland, both in weather and finance.)
In conclusion, the diagnosis of the crisis is wrong and the policy prescription on this basis will be wrong as well. As in other parts of life, two wrongs don’t make it right. Expect euro wobbles to be with us in 2011 and beyond.