Emergency Liquidity Assistance and Systemic Risk
Embargoed until: 2019-01-01
Embargoed until: 2019-01-01
Systemic Risk, Institutional Design, and the Regulation of Financial Markets
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Responses to the global financial crisis that commenced in 2007 and reached its zenith in 2008 included unprecedented central bank emergency liquidity assistance (ELA) and a myriad of bailout programmes (comprising guarantees, recapitalisation, other forms of government support and even nationalisation) that compromised the fiscal position of some countries, notably Eurozone Member States, leading in some cases to a sovereign debt crisis (the doom loop or vicious link between bank debt and sovereign debt). The expansive use of lender of last resort (LOLR) has been a defining and evolving feature of the responses to the crisis. Central banks around the World operated as lenders of last resort, market makers of last resort and, at times, lenders of primary resort or lenders of only resort. This extraordinary provision of liquidity assistance was done by central banks working under their own statutory requirements (that is domestic law, with the exception of the ECB, whose primary law is a Treaty), thus highlighting the dichotomy between national law and global markets. Financial history must be rewritten following the experience of the last nine years. Notwithstanding the recurrent nature of financial crises, and the presence of some elements that are common in previous episodes (such as the boom and bust of housing finance), a novel characteristic of the recent crisis is the new understanding of systemic risk (no longer confined to banking with the advent of SIFIs, systemically important financial institutions) and the use of macro-prudential tools to combat it. The magnitude of the responses by the public authorities to tackle systemic risk also raises issues about their ability to confront future crises. This chapter provides a revisionist account of liquidity support, leaving aside solvency support, in the aftermath of the crisis. It is not so much what we know about the various tools used so far, but what we do not know about the reverberations of central bank policies concerning ELA and QE that poses significant economic, legal and political challenges. The chapter adopts a comparative perspective in the analysis of ELA/LOLR and discusses the effectiveness of this instrument in the prevention and containment of systemic risk. The challenge remains to design adequate regulatory structures that transcend the domain of domestic jurisdictions in order to regulate such risk adequately. Following this introduction the chapter is divided into four sections. Section 2 deals with some definitional issues concerning lender of last resort, systemic risk and financial stability. Section 3 considers the multi-dimensional nature of lender of last resort, as a crisis management instrument, a macro-prudential tool in the pursuit of financial stability, a monetary policy instrument and the classic exercise of the central bank’s role as bankers’ bank. Section 4 examines critically the notion of constructive ambiguity, and the need for a clear legal framework that permits ample discretion and flexibility, balanced by adequate mechanisms of accountability. Section 5 presents a comparative analysis of recent developments in the UK, US and eurozone/banking union, looking both at individual liquidity assistance and market liquidity assistance. As regards the eurozone, the EU rules on state aid and the interaction between monetary policy, macro prudential supervision and liquidity assistance are also considered. The chapter finishes with some concluding observations.
- Department of Law