The role of central banks as lender of last resort

Abstract

The history of many central banks is intrinsically connected to the need to create a mitigating mechanism in times of financial crisis. A key role at the disposal of the central banks is that of being the Lender of Last Resort (LOLR). The LOLR concept is fundamental to central banking and has traditionally been based on Bagehot's Principle which states that: ‘to stem a financial panic a central bank should lend freely at a penalty rate to solvent institutions against good collateral.’ In their role as LOLRs, central banks act at their discretion by providing emergency capital to alleviate financial crises. The LOLR's discretion stems from the need to avoid moral hazard. This discretionary role of central banks as LOLR, however, came under intense scrutiny during the 2008 Global Financial Crisis (GFC), when many central banks invented and experimented with various financial products to mitigate the Crisis, deviating from Bagehot Principle in the process. The central banks' execution of their LOLR role during the GFC drew both praise and criticism, raising concerns about the legitimacy of this critical role. This thesis seeks to explore the concept of LOLR and considers the theories regarding this critical role of central banks. The study further analyses the history of central banks and how they evolved in their reactions to financial crises during the 200 years before the 208 GFC. The thesis then explores the events leading to the GFC, the causes of the GFC, and how the Crisis unfolded, including the reaction of prominent central banks across the globe to the Crisis. The study specifically interrogates the responses of selected prominent central banks to the 2008 GFC against the backdrop of the traditional Bagehot principle of LOLR. It also explores the lessons that central banks can learn from their mitigation arrangements during the GFC as well as the pertinent reforms in financial regulation in the wake of the GFC, focusing on the global reaction as well as the reaction of selected major central banks. It takes guidance from the traditional Bagehot Principle and the application of the LOLR role by central banks during the GFC as well as developments post-GFC. The study is concluded with recommendations for the creation of a rules-based legal framework (model law) for the future application of the LOLR by also considering the lessons learnt from the GFC and relevant legal reforms in the financial sector post-GFC.