Journal of Applied Finance & Banking

Alternatives to the public sector lender-of-last-resort

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  • Abstract

    After the 2008 financial crash governments and central banks had to rescue banks which had become insolvent or illiquid, and whose failure threatened the Western financial system. The bill for this taxpayer funded bailout came to over USD 20 trillion globally, including assistance from US, EU, UK and Japanese governments and the IMF, and had an impact on medium term economic growth prospects. It also triggered public indignation as the taxpayer perceived that rescues of this kind solidified an unfair institutional system in which profits are privatised but losses are socialised. The events of 2007-2009 and the recent eurozone sovereign credit crisis have re-ignited the debate on the principle of the taxpayer-funded central bank lender of last resort (LOLR) and the issues around moral hazard. In this article we re-visit the shortcomings of the current public sector LoLR arrangement and investigate whether a viable alternative exists to support banks that are experiencing funding stresses. We focus on alternatives to the public sector central bank being the backstop liquidity provider of last resort for a bank experiencing funding (as opposed to capital loss) stress, and recommend a viable solution that would minimise taxpayer exposure at the time of the next crash.