This piece from Vox Eu provides a good run down of one of the issues of that exists when we have a central bank as a lender of last resort – moral hazard.
The prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner.
As long as we need a lender of last resort to prevent against bank runs – we also need to lean against the moral hazard implicit in any of this sort of support.
The question I have is, how do we then try to make banks price in the full social risk of their actions, when they are protected in the “worst case scenario”. In essence this suggests there is some “externality” and so we will want to have some type of “externality tax” for these banks.
However, this is an issue we need to look into, I see the argument as follows:
- We require a lender of last resort function for central banks, to prevent bank runs on solvent banks facing liquidity issues.
- However, this function creates a moral hazard problem – because some of the downside risk is socialised
- Given that, how can we solve the moral hazard issue?
This is one of those cases where the initial issue (bank runs) is serious enough that it seems worth dealing with the unintended consequences directly – instead of dumping the policy of a “lender of last resort” completely 😉