Norges Bank's role in the event of liquidity crises in the financial sector.

• Author: Gerdrup, Karsten R.

Central banks have traditionally had a role as lender of last resort (LLR). This means that the central bank can supply extraordinary liquidity to an individual bank or the banking system when demand for liquidity cannot be met from other sources. This role has changed over time for Norges Bank. In the course of the past 30 years, the stance on extending loans on special terms (S-loans) to banks has become more restrictive. This is partly attributable to the liberalisation of credit markets and increased opportunities for banks to raise funds in the market. Following the banking crisis, Norges Bank's attitude to providing extraordinary liquidity for the individual bank has remained unchanged. The Executive Board's most recent review of the Bank's role as LLR, in March 2004, confirms that extraordinary provision of liquidity should be reserved for situations in which financial stability may be threatened without such support. The review also clarified the Bank's reaction to different types of liquidity problems and its criteria for granting S-loans.

1. Introduction

Through its conduct of monetary policy, Norges Bank normally ensures that the liquidity in the banking system is such that the shortest money market rates remain close to the key rate. In crisis situations, the supply of liquidity through the Bank's ordinary lending facilities may rapidly prove to be inadequate. The central bank must then consider extraordinary measures. A distinction can be made between a liquidity shortage for the individual bank, and for the banking system as a whole.

In the event of a shortage of liquidity in the market, for example as a result of a general loss of confidence in a country's economy and banks, or a credit crunch in international capital markets, both short-term and long-term rates may rise and asset prices may drop sharply. Such crises may therefore have macroeconomic consequences, and the central bank may have a special responsibility for helping to avert a crisis by providing an extraordinary supply of liquidity.

An individual bank may have liquidity problems even under normal market conditions, for example as a result of a loss of confidence on the part of lenders. Central banks do not normally have a responsibility to resolve liquidity problems in such cases, unless there is a possibility of severe knock-on effects for other banks (through the interbank and payment systems) and the economy in general. When crises in one or more banks are attributable to weak risk management and a decline in financial strength, other measures will also be necessary.

In Norway, part of the Ministry of Finance's general responsibility for economic policy entails ensuring that the country has a smoothly functioning financial industry. The Ministry's responsibility also includes legislation pertaining to the area of finance. In crisis situations, the Ministry may consider whether crisis-hit banks should be placed under public administration, be supplied with capital/subordinated loan capital from the state, or whether other crisis measures should be implemented. Kredittilsynet (the Financial Supervisory Authority) is responsible for overseeing the individual institution and has been granted broad powers to intervene in the event of crises or potential crises by issuing requirements and instructions to the individual institution.

Some general remarks about the role of LLR are presented in Section 2. Section 3 contains a more detailed account of how this role has developed over the last 30 years in Norway. Section 4 describes the situation today, while Section 5 presents a summary.

2 The role of LLR and Norges Bank's instruments

2.1 Theoretical considerations

In the 1800s, Thornton (1802) and Bagehot (1873) outlined the elements of the central bank's LLR policy. The key elements were that in the event of liquidity crises, the central bank should be prepared to supply liquidity on a large scale, against provision of satisfactory collateral and at a high interest rate. Satisfactory collateral was considered necessary so that central banks did not have to conduct a credit assessment in each individual case. In practice, the posting of collateral took the form of banks discounting bills of exchange in the central bank. The central bank was able to increase the supply of liquidity by accepting several types of bills (for example bills with a longer residual maturity than was normally accepted). The cost to the central bank was that a broader set of bills normally meant poorer securities quality and a higher credit risk. A high interest rate was viewed as necessary to reduce moral hazard in banks and to encourage market-driven solutions. It might also be necessary to maintain a high interest rate in order to avoid flight of capital and outflow of gold, which, under the gold standard (and fixed rate regimes generally) could lead to a decline in the money supply and provision of credit, deflation and economic downturns. Although these recommendations were made under a different regime in terms of exchange rate system, regulation and oversight, they still apply. (2)

Liquidity problems may arise for many reasons, in the form of a liquidity shortage for an individual bank or the banking system as a whole. Bagehot and Thornton appear to have been of the opinion that the central bank should primarily supply liquidity to the market by general means, and let the interbank market handle the distribution of the liquidity. (3) This is because banks that are sound and have good risk management systems will normally enjoy confidence in the markets, and will therefore also have adequate access to liquidity. (4) If the central bank grants extraordinary loans to the individual bank too frequently, lenders to banks may have less incentive to monitor the banks' financial situation and may provide credit too cheaply. This may induce banks to take too much risk. Reliance on extraordinary support from the central bank may also make banks less motivated to find market solutions in the event of liquidity problems. The result may be a less stable banking system.

However, the possibility cannot be excluded that even sound banks may suffer a loss of confidence on the part of depositors and other creditors because they are less well informed about the quality of banks' assets than the banks' management. This is referred to as 'asymmetric information'. When liquidity problems compel a bank to sell its assets, creditors may incur substantial losses. In such cases it may be maintained that the central bank should grant extraordinary loans to the crisis-hit bank in order to avoid an ineffective winding up of a bank that is fundamentally sound. In practice, however, it is very demanding for the central bank or supervisory authorities to evaluate the financial strength of a bank in a short space of time, both because of asymmetric information and because the bank itself does not have full information. The central bank therefore risks incurring a loss if it provides a loan and the market's assessment later proves to be well-founded.

A basic principle is that central banks should not extend loans to banks with solvency problems. In principle, such problems should be solved by the owners supplying fresh capital, or through mergers or acquisitions by private-sector operators. In countries with guarantee funds with a mandate to supply risk capital, as in Norway and the US, the guarantee funds come in as the second line of defence. If a bank is not supplied with sufficient capital to enable it to continue operating in a prudent manner, it will have to be wound up. In Norway, financially weak banks may be placed under public administration. In the event of a systemic crisis, however, public administration may not be very appropriate, because it may have negative consequences for overall provision of credit and the payment system. In such cases the government may intervene as the ultimate authority and supply capital to crisis-hit banks, or take other steps to avert a crisis. (5)

If problems in a bank are discovered early and handled rapidly and efficiently, the need for the central bank to supply extraordinary liquidity or for government authorities to provide solvency support will be less or nonexistent. Calculations show, for example, that a swifter, more efficient handling of the crisis in US savings and loan institutions in the 1980s could have resulted in a considerable reduction in costs to the government (Goodfriend (2001)). Instead, the authorities allowed the banks to continue operating with limited financial strength, with the result that they increased their risk (gambled for resurrection), and their financial strength deteriorated further.

2.2 What instruments are available to Norges Bank?

Although a great deal has been written about the role of LLR, no clear, consensual definition of the role of LLR exists either in theoretical work or in practice. This article takes as its starting point Norges Bank's established lending arrangements and then describes the Bank's policy regarding the injection of extraordinary liquidity into an individual bank or the banking system as a whole.

Norges Bank's lending arrangements can be divided into two main groups:

* General:

--Monetary policy instruments (fixed-rate loans and deposits and currency swaps)

--Standing facilities for settlement of interbank claims (intraday loans/sight deposits) via Norges Bank's settlement system (NBO)

* Loans on special terms to a bank (S-loans)

Norges Bank has distinguished between general loan arrangements and S-loans since the Credit Act was introduced in 1965. However, the structure of the arrangements has varied over time.

The aim of Norges Bank's liquidity policy today is that the banking system as a whole shall have substantial sight deposits in the central bank at the end of the day. Should a need to borrow arise, Norges Bank will supply the liquidity that is necessary by...