The Role of the Central Bank

Introduction Nowadays, monetary and central bank policy become more and more important. Besides, many references are regularly made to the function of central bank as lender of last resort(LOLR). LOLR contributes a lot to solve the financial crises. As central banks are independent from government, they seem to have strong priorities. In modern society, with the growth of the global economy, central banks have been playing especially important roles in finance systems of modern society(Goodhart& Illing,2002) . The main responsibility of a central bank is to manage the monetary policy in order to keep the economy as well as currency stable.

Then, the central banks can manage inflation and deflation. Besides, central banks have to hold foreign exchange reserves. The role of central bank as lender of last resort plays a crucially important role in providing liquidity when financial situation depresses. However, this role suffers great controversy. In an attempt to have a further insight into the roles of central banks, the controversy of LOLR is introduced in this essay. It is vital to analyze this important central bank function in order to better understand this function of central banks.

The purpose of this essay is to discuss the role of an LOLR and the controversy of the role(Freixas&Parigi, 2008). The essay is structured as below. Section 2 discusses what is a central bank and its functions in the monetary and financial area. Section 3 introduces the role of the central bank as lender of last resort. Then, it is deeply discussed in section 4 that why LOLR is controversial. A conclusion of how the central banks will develop complete the essay. 2. Central Bank 2. 1 Concept of The Central Bank A central bank is a public institution that manages interest rates, the currency and money supply of a state.

Central banks of their respective countries also usually supervise the system of commercial banking. A central bank is different from a commercial bank, it holds a monopoly on enhancing the monetary base of one nation. That is to say, the central banks regulate the amount of the nations’s money supply and the foreign exchange value of the nations’s currency. Besides, the national currency is printed by the central bank of this country. It is a modern central bank’s principal purposes to make monetary and financial conditions beneficial to an enough level of international reserves, a high rate of production and employment.

2. 2 Functions of The Central Bank By adjusting interest rates, setting the reserve requirement and acting as a lender of last resort when a financial crisis or bank insolvency happens, a central bank performs it primary function—-managing the nation's money supply. It manages a country's gold reserves and foreign exchange. In addition, in order to reduce the danger that commercial banks and other financial institutions have when doing financial behaviors, central banks regularly have powers to regulate and supervise the banking industry as well.

Thus, central banks are independent from the government in most developed nations. Role of A Central Bank as LOLR 3. 1 History of LOLR The LOLR has a long long history. There is a classical view hold by Bagehot’s (1873) stated that the LOLR role should fulfill at least three requirements below: (i) the loans should be lend to only solvent institutions and on good collateral, (ii) the loans must be at a penalty rate in order to prevent the to use the loans to finance for their daily operations, (iii) the central bank make sure that a bank that is willing to pay back satisfies the requirements above.

That is to say, they have the ability to liquidate and warrant (Parigi&Rochet, 2003). 3. 2 Definition of LOLR A lender of last resort is an institution which is willing to provide credit in the last position even when no one will extend credit. In most situations, it is often the central bank of a country who plays this role, in order to avoid commercial banks to go into bankruptcy. When commercial banks are considered in high risk, a country's central bank usually provides loans to commercial banks and some reasonable institutions that are suffering financial difficulty.

A lender of last resort can not only protect depositors but also prevent withdrawal caused by widespread panic. Thus, it can prevent the entire economy from being collapsing. Commercial banks don’t borrow from the lender of last resort ordinarily. Only when a financial crisis happen will they use this life-saving straw. This phenomenon exits because if a institute borrows from a central bank, it means a suffering from too much risk and financial difficulties(David, 2002). In the United Kingdom, the role of LOLR is acted by the Bank of England.

In the same way, this role is undertaken by the Bank of Japan in Japan and by the Swiss National Bank in Switzerland. Similarly, inRussia, the role of LOLR is played by the Central Bank of Russia. When a financial institution is experiencing financial difficulties and is not able to fund money from everywhere else, a central bank may be the one which will offer it an credit. The central banks’ main task is to protect the commercial banks from getting into a liquidity problem. It should protect the individuals’ funds as well.

In addition, the central bank have the ability to keep the banks from over withdraws in order to maintain their liquidity and remain stable. It is the central banks who have been acting as lenders of last resort hence to avoid great depressions when financial crisis happened for more than century and a half. From the beginning, the LOLR provides liquidity at a penalty rate. And then it lowers interest rates on safe assets through hen a financial institution is experiencing financial difficulties and is not able to fund money from everywhere else, a central bank may be the one which will offer it an credit.

The central banks’ main task is to protect the commercial banks from getting into a liquidity problem. It should protect the individuals’ funds as well. In addition, the central bank have the ability to keep the banks from over withdraws in order to maintain their liquidity and remain stable. It is the central banks who have been acting as lenders of last resort hence to avoid great depressions when financial crisis happened for more than century and a half. At first, this act provides liquidity at a penalty rate.

And then interest rates of safe assets becomes lower because of the open market operations, . At last, the LOLR contains support of direct market . Just as what has been discussed above, when financial situation depresses, a LOLR provides the function to offer liquidity. In traditional theory, a central bank should lend with no reason in a bank’s crisis. This theory proves that an effective interbank market could be useful to assure that banks have enough liquidity. This is, however, out of work when a crisis takes place in the interbank market. 3. 3 Importance of Central Bank as LOLR

Central banks is always the fist authority to find some problems related to the liquidity in the money markets. Central banks could ascertain some warning signs, for example, overnight liquidity shortages in commercial banks; delays of settlement; failures or delays to solve interbank transactions(Sveriges Riksbank, 2003; William& Moessner, 2010). It has been a long history for a central bank to play a role as the lender of last resort for financial institutions such as commercial banks. The main commercial banks were always influenced by central bank as lender of last resort.

These commercial banks include the Bank of England, the Bank of Japan, the Swiss National Bank and the Federal Reserve System in the United States. Only when a lender of last resort can give the wealth to the depositors, will a bank’s liabilities being declined. After the central bank has taken this liability, it is reduced. However, it is not eliminated at all. The central bank as a lender of last resort come into being because commercial banks fail to undertake the costs when a breakdown of crisis or a credit risk happens. Besides, a LOLR can make it less possible for the asset values to decline.

Controversial LOLR Function 4. 1 Why Controversial Although LOLR is an crucial role for a central bank to play, it is controversial as well for it produces moral hazard. A LOLR function may promote banks to risk more and more, then decrease the supervision of banks by creditors(Repullo, 2000). The help made by central banks to commercial banks may lead to an excess supply of money. It is hard for the money market come back to equilibrium. How the market operates depends on the regime of exchange rate, the development of the market and the efficiency of finance market.

When the exchange rate is fixed, an excess liquidity can make the international reserves decrease. Therefore, unless this liquidity is neutralized by open market operations, the excess liquidity may lead to a currency crisis. Similarly, when a country is in flexible exchange rate regime, the currency market may easily turn back to equilibrium because there is an adjustment between exchange rate and interest rate when the securities markets is well developed and mature enough. It is argued by the liberals that the crisis’s origin is always what the investors though they had guarantees.

The crisis is just combined the limited risk and high profitability. This is because the lender of last resort could lead to a overload of investment in emerging economies. The controversy is that the central bank should be limited when it is acting as a lender of last resort in order to avoid wrong expectations. When the long term investment of emerging countries did not afford the government to pay for the short term liabilities, these countries will suffer a liquidity crisis. The lender of last resort will affect what the economic agents decide. However, as the moral hazard problem exists, it is less effective.

4. 2 How to Protect LOLR Function In many developing countries additional requirements are needed to reduce moral hazard and protect the LOLR from undue political pressure, including well designed lending procedures, clearly laid out authority and accountability. As the financial environment is changing consequently, some measures must be taken to develop the central banks as a lender of last resort. To begin with, the central banks should work out an system in order to limit the moral hazard problems. It is the lender of last resort’s responsibility to watch and guide to use them correctly(Kahn&Santos, 2001).

The central bank should not only regulate the interbank but also the payment system. It must overlook the OTC derivatives as well. People who use this service should pay for it. Thus, the central bank as a lender of last resort must need guarantees to prevent a systemic risk. By doing this, the whole system will be led to a right way, although there are still large risk in OTC derivatives and the interbank market. Besides, the central banks may not always use their roles as lender of last resort due to a reduction of the costs in a bank breakdown.

And the deposit insurance emerges, it means that the moral hazard problems will be less able to happen. The most reasonable version is that the institutions which are in financial trouble will accept less support than before in the near future. Thus, the market discipline may be much more stricter. Furthermore, the central banks can lend not only by the open market operations, but also through other directions. Indeed, if a central bank can only intervene the financial market through open market operations, it is not effective to development of liquidity.

It is due to the large risk when a financial crisis happens and an exceeding expenditure of liquid assets(Maurice, 2009). Conclusion The purpose of this essay is to make it clear that what a real function of a lender of last resort the central bank offers in financial activities and why it is controversial. For the most part, the controversy is on the moral hazard a lender of last resort creates. Of course, a conclusion should be reached from what has been discussed above that the central bank plays an important and vital role as a lender of last resort.

However, people should not neglect the moral hazard it makes. All of the classical controversies are related to money stocks. It is worthwhile to point out the controversy of the role of central banks as lender of last resort and to give some effective solutions on this problem. Next, the government should be thinking of how to carry out these measures. 6. References Bagehot, W. (1873). Lombard Street: A Description of the Money Market. H. S. King, London. Freixas, X. and Parigi, B. (2008). Lender of Last Resort and Bank Closure Policy. CESifo Working Paper, n°2286. X. Freixas, B.

M. Parigi and J. -C. Rochet. (2003). The lender of last resort: a 21st century approach. Goodhart, C. and G. Illing (2002) Introduction to Financial Crises, Contagion, and the Lender of Last Resort. A Reader, Goodhart and Illing (eds. ). Oxford University Press, Oxford, 45-67. Repullo, R. (2000). Who Should act as a Lender of Last Resort? An Incomplete Contract model . Journal of Money, Credit and Banking, 32: 3, 580-605. Sveriges Riksbank. (2003). The Riksbank’s role as a lender of last resort. Financial Stability Review, No. 2, Stockholm, 203-213. Kahn, C. M. and J. A. C. Santos.

(2001). Allocating bank regulatory powers: lender of last resort, deposit insurance and supervision ” Bank for International Settlements, WP n. 102. Fettig, David (2002). Lender of More Than Last Resort. The Region, Federal Reserve Bank of Minneapolis, 56-64. Allen, William A. and Richhild Moessner. (2010). Central Bank Co-operation and International Liquidity in the Financial Crisis of 2008-9. Bank for International Settlements Working Papers No. 310, 15-23. Obstfeld, Maurice. (2009). Lenders of Last Resort and Global Liquidity: Rethinking the System. Development Outreach 11, 3, 1-4.