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Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis?

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  • Economics

Abstract

Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis? 111 Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis? Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis? E Philip Davis1 Abstract Liquidity risks are endemic to banks, given the maturity transformation they undertake. This gives rise to risk of bank runs, the fi rst line of defence against which should be appropriate liquidity policy of banks. Nonetheless, solvent banks can face liquidity diffi culties at times of stress, necessitating liquidity support. The traditional role of the lender of last resort (LOLR) is to avoid unnecessary failures that could threaten systemic stability, while ensuring that there are suitable safeguards for central bank balance sheets and that moral hazard is minimised. The sub-prime crisis has shown that traditional models of bank liquidity risk and of LOLR require revision, as was already apparent to a lesser extent in the Long-Term Capital Management (LTCM) episode. Funding risk now interacts with market liquidity risk to create diffi cult challenges for central banks. The LOLR has had to adapt radically, for example, in terms of lending to investment banks, taking lower-quality collateral and lending at longer maturities. Central banks have also been challenged by diffi culties in maintaining confi dentiality of support and by the interaction of these problems with low levels of deposit insurance. 1. Introduction This paper seeks to assess the importance of liquidity in fi nancial crises and how the authorities may deal with it. It starts from the concept of bank runs – whereby the nature of banking means that solvent banks may at times be subject to panic runs and consequent illiquidity – and their ubiquity in most crises to date. Contagion may arise via credit risk linkages to other banks. This is

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