Banks can borrow from the Federal Reserve’s/ Central Banks discount window. While discounting is a tool of monetary management, the 1 Fed/CBK can also use discounting to prevent bank panics. When the Fed acts this way, it is acting as the lender of last resort to the bank. When depositors know the Fed is standing by as the LLR they have
more confidence in the bank’s ability to withstand a panic and are therefore less likely to withdraw if financial trouble is looming.
When crisis prevention fails Central Bank as LLR has an obligation to deal with the consequences at minimum cost. Central Banks intervention must be decisive. Owners and managers must incur substantial losses. Besides, the Central Bank should not unnecessarily be drawn into LLR financing of banks and exposure to major credit risks.
Only in a systemic case should the Central Bank deal with the crisis. Where the Central Bank directly or indirectly funds pay outs through deposit insurance the issue of limiting monetisation arises.
Bagehot 1873 classic, in a crisis the lender of last resort should lend freely, at a penalty rate on good collateral. Meltzer (1986) argues that insolvent financial institutions should be sold at market price or liquidated if there are no bids for the firm. The losses to be borne by owners of equity, subordinated debentures, uninsured depositors and the
deposit insurance fund. The discount window should be opened only in times of systematic failure, but be freely available to all institutions that are creditworthy and who provide substantial amounts of liquidity insurance.
Deposit insurance, moral hazard and adverse selection
Deposit insurance is a guarantee that all or part of the amount deposited by savers ina bank will be paid in the event that a bank fails. The guarantee may be either explicitly given in law or regulation, offered privately without government backing or may be inferred implicitly from the verbal promises and/or past actions of the authorities. In
recent years, many nations have adopted or are considering a system of explicit or formal deposit insurance. Deposit insurance may encourage bankers to make risky loans because depositors no longer have reason to withdraw their funds from carelessly managed banks. Therefore deposit insurance presents the danger that bad business
judgements will distort the market. Ricki Tigert Helfer (1999) argues that anything that encourages risky behavior by leading financial risk takers to believe that they will reap the benefits of risky investment they make while being protected from the losses is a moral hazard.
Diaz Alejandro 1985 argues that like any other insurance scheme, deposit insurance is vulnerable to moral hazard consequences i.e. it induces depositors to think that onebank is as good as another and leads bank managers to undertake riskier loans. This
follows from Maxwell Fry (1995).A bank accepts deposits at competitively determined terms that are set before the bank makes its project choices. The bank then has an incentive to invest in projects if riskier projects carry higher repayment obligations from entrepreneurs to the bank. This is asset substitution moral hazard.
Under deposit insurance there is a balancing act, assure financial stability when liquidity and solvency problems arise but at the same time minimising moral hazard. To limit moral hazard, the market place should be allowed to discipline financial risk takers by letting insolvent institutions to fail. Those that come close to failing should pay hefty costs; this could be in the form of high interest costs on short-term liquidity support. In general insolvent banks should be left to fail and shareholders lose their equity. In the case of too big to fail, countries have to save institutions to ward off systemic problems.
As Ricki Tigert Helfer indicates a reasonable balance between moral hazard and a stable financial system would permit a very limited exception for failures that pose a systemic risk, while letting the market discipline improvident behaviour.
The too big to fail doctrine imposes moral hazard on the investors. They no longer have the responsibility to investigate the soundness of the institutions in which they deposit their funds. The doctrine is immoral. It segregates the industry. The big banks can afford to take considerable risk/moral hazard incentives whereas the small banks are
constrained. Besides it accords an unfair competitive advantage over small banks apart from reducing depositor incentive to police their banks. It also conflicts with the tenets of a discipline encouraging market friendly DI as outlined by Garcia and Carl-Johan Lindgren (1996).