Week 2&3

Different types of secondary banking and the respective regulatory framework

Glass-Steagall Act of 1933

🠶 Definition: The Glass-Steagall Act is a law that prevented banks from using depositors'
funds for risky investments, such as the stock market.
It was also known as the Banking Act of 1933. It gave power to the Federal Reserve to
regulate retail banks. It also prohibited bank sales of securities.
It created the Federal Deposit Insurance Corporation (FDIC).
🠶 Glass-Steagall separated investment banking from retail banking. Investment banks
organize the initial sales of stocks, called an Initial Public Offering. They facilitate
mergers and acquisitions. Many of them operated their own hedge funds. Retail banks
take deposits, manage checking accounts and make loans.

When Was It Passed?

🠶 Glass-Steagall was passed by the House of Representatives on May 23, 1933. It was
passed by the Senate on May 25, 1933. It was signed into law by President Roosevelt on
June 16, 1933. It was originally part of his New Deal . It became a permanent measure in
1945.
🠶 It is named after Senator Glass and Congressman Henry Steagall, who introduced the
relevant legislation that bears their name.

The main objectives

🠶 Glass-Steagall Act was issued in order to limit the conflict of interest created by the
ability of commercial banks to be underwriters and securities. The new legislation
forbade commercial banks to be underwriters of securities, compelling them to choose
whether to operate from that moment onwards either as commercial or as an
investment.
🠶 As it is analyzed in the next transparency, the examining law was also established in
order to guarantee bank deposits, via the Federal Deposit Insurance Corporation (FDIC)
and strengthened the role of the FED.

Glass-Steagall Act of 1933: Other purposes

🠶 It gave response to the failure of nearly 5,000 banks during the Great Depression. In
1933, all U.S. banks closed for four days. When they reopened, they only gave depositors
10 cents for each dollar. Where did the money go? Many banks had invested in the stock
market, which crashed in 1929. When depositors' found out, they all rushed to their
banks to withdraw their deposits.
🠶 Even sound banks usually only keep one tenth of the deposits on hand. They will lend out
the rest because they know that normally that's all they need to keep on hand to keep
their depositors' happy. However, in a bank run, they must quickly find the cash. Today,
we don't have to worry about bank runs because the FDIC insures all deposits. Since
people know they will get their money back, they don't panic and create a bank run.

The main reasons

🠶 After the crash in 1929, an attempt was made to identify the causes that led to the
collapse of markets in order to adopt the necessary measures to prevent the recurrence
of such phenomena. The Glass-Steagall Act of 1933, (based on the regulation of US
financial edifice) imposed a clear separation of commercial banks (ie, aim to lend money)
from investment banks (ie, sale of bonds, shares etc) . The two types of banks no longer
had conflicts of interest. Depositors were more confident that the commercial bank
 woulnd’t place their savings in high-risk investments.

Commercial versus Investment Banking, Congressional: Main Weaknesses

The Case for Preserving the Glass-Steagall Act:
1.Conflicts of interest characterize the granting of credit - lending - and the use of credit -
investing - by the same entity, which led to abuses that originally produced the Act.
2. Depository institutions possess enormous financial power, by virtue of their control of other
people's money. Its extent must be limited to ensure soundness and competition in the
market for funds, whether loans or investments.
3. Securities activities can be risky, leading to losses. Such losses could threaten the integrity of
deposits. In turn, the Government insures deposits and could be required to pay large sums
if depository institutions were to collapse as the result of securities losses.
4. Depository institutions are supposed to be managed to limit risk. Their managers may not be
conditioned to operate prudently in more speculative securities businesses.

The case against preserving the Glass-Steagall Act:

1. Depository institutions will now operate in "deregulated" financial markets in which
distinctions between loans, securities, and deposits are not well drawn. They are losing
market shares to securities firms that are not so strictly regulated and to foreign financial
institutions operating without much restriction from the Act.
2. Conflicts of interest can be prevented by enforcing legislation against them and by
separating the lending and credit functions through forming distinctly separate subsidiaries
of financial firms.
3. The securities activities that depository institutions are seeking are both low-risk and would
reduce the total risk of organizations offering them, by diversification.
4. In much of the rest of the world, depository institutions operate simultaneously and
successfully in both banking and securities markets. Lessons learned from their experiences
can be applied to our national financial structure and regulation.

Repeal of Glass-Steagall
🠶 Glass-Steagall was repealed in 1999 by the Gramm-Leach-Bliley Act. The
Gramm-Leach-Bliley Act was passed along party lines by a Republican vote in the Senate.
Actually, it was named after Senator Phil Gramm, the Deputy Jim Leach and Thomas J.
Bliley Jr., chairman of the House Commerce Committee.
🠶 The banking industry had lobbied for the repeal of Glass-Steagall since the 1980s. They
complained they couldn't compete with other securities firms. The banks said they would
only go into low risk securities. They wanted to reduce the risk for their customers by
diversifying their business.

The Gramm-Leach-Bliley Act (1999):

The main reasons
🠶 The Gramm-Leach-Bliley Act (1999) also known as the Financial Services Modernization
Act. This ends the separation between commercial and investment banks. The main
reason for this termination was the competitive disadvantage of American banks in
particular in relation to European (Deutsche Bank, UBS, Credit Suisse etc) that lead to
disintermediation and loss of market share from US banks. Also argued that such a
consolidation would stabilize the banking market regardless of point in the economic
cycle. In times of recession deposits are growing and bond issues are reducing and vice
versa.
🠶 In 1999, the government of the USA, reversed one of the key elements of the
Depression-era banking laws, knocking down the firewall between commercial banks,
 which take deposits and make loans, and investment banks, which underwrite securities.
So, The repeal of the Glass-Steagall Act of 1933 was seen at the time as a way to help
American banks grow larger and better compete on the world stage.
🠶 Actually, the Congress voted to update the rules that have governed financial services
since the Great Depression and replace them with a system for the 21st century.
Indicatively, the Treasury Secretary Lawrence H. Summers said at the time. “This historic
legislation will better enable American companies to compete in the new economy.”

Universal Banking Model

🠶 Universal banking is the conduct of a variety of financial services such as:
🠶 trading of financial instruments; foreign exchange activities; underwriting new
debt and equity issues; investment management, insurance; as well as extension of
credit and deposit gathering
🠶 Universal banks have long dominated banking in most of continental Europe. Universal
banks engage in everything from insurance to investment banking and retail banking—
🠶 similar to U.S. banks prior to the enactment of the Banking Act of 1933 and
Glass-Steagall provisions

Advantages of Universal Banking:

Risk Diversification and Expanded Business Opportunities
🠶 A universal bank can spread its costs over a broader base of activities and generate more
revenues. Diversification, in turn, reduces risk.
🠶 insurance companies, investment banks and other suppliers of financial services
are moving toward building financial conglomerates
🠶 Technology firms (such as Microsoft) are hammering away at banks' networks-building
the electronic gateways into financial services.

Disadvantages of Universal Banking:

Inherent Conflict of Interest
🠶 There is an inherent conflict of interest:
🠶 A universal bank might use pressure tactics to coerce a corporation into using its
underwriting services or buy insurance from its subsidiary by threatening to cut
off credit facilities.
🠶 It could force a borrower in financial difficulties to issue risky securities in order to
pay off loans.
🠶 A universal bank could also abuse confidential information supplied by a company
issuing securities as well.

The Gramm-Leach-Bliley Act (1999): The main reasons of its repeal

🠶 The repeal of Glass-Steagall consolidated investment and retail banks. That led to banks
becoming too big to fail. This required their bailout in 2008-2009 to avoid another
depression.
🠶 Apart from the above, some other crucial problems were arising, attributable to universal
banks, after the implementation of Gramm-Leach-Bliley Act: such as Securitization,
increased systemic risk, etc.

Malfunctions result from the implementation of the Gramm-Leach-Bliley Act (1999):

Some critical views/aspects
🠶 “By the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying
effort that drove deregulation was more about facilitating mergers than creating an
efficient regulatory framework” (Obama,2008). and he added: “Instead of establishing a
21st century regulatory framework, we simply dismantled the old one,” thereby
encouraging “a winner take all, anything goes environment that helped foster devastating
 dislocations in our economy.”

Should Glass-Steagall Be Reinstated?

🠶 Congressional efforts to reinstate Glass-Steagall have not been successful. In 2011, H.R.
1489 was introduced to repeal the Gramm-Leach-Bliley Act and reinstate Glass-Steagall.
If these efforts were successful, it would result in a massive reorganization of the banking
industry. The largest banks include commercial banks with investment banking divisions,
such as Citibank, and investment banks with commercial banking divisions, such as
Goldman Sachs.
🠶 A reinstatement of Glass-Steagall would better protect depositors. At the same time, it
would create organizational disruption in the banking industry. This might be a good
thing, as these banks would no longer be too big to fail, but it should be managed
effectively.
🠶 However, the banks argued that reinstating Glass-Steagall would make them too small to
compete on a global scale.
Part 2
The origin of Dodd-Frank Wall Street Reform Act
🠶 The Dodd-Frank Wall Street Reform Act was passed instead of the absolute
reinstatement of the Glass-Steagall Act.
🠶 A part of the Dodd-Frank Wall Street Reform Act, known as Volcker Rule, puts
restrictions on banks' ability to use depositors' funds for risky investments. But it does
not require them to change their organizational structure. If a bank becomes too big to
fail and threatens the U.S. economy, Dodd-Frank requires that it be regulated more
closely by the Federal Reserve.

Dodd-Frank Wall Street Reform Act (2010):

When Was It Passed?
🠶 The Dodd-Frank Act was named after the two legislators who created it. Senator Chris
Dodd introduced it on March 15, 2010, and ushered it through the Senate on May 20.
🠶 The bill was revised by Congressman Barney Frank and approved by the House on June
30. On July 21, 2010, President Obama signed the Act into law.

Dodd-Frank Wall Street Reform Act (2010): Its importance

🠶 The Dodd-Frank Wall Street Reform Act was the most comprehensive financial reform
since the Glass-Steagall Act. As mentioned previously, the Gramm-Leach-Bliley Act,
allowed banks to use deregulated derivatives, causing the 2008 financial crisis.
🠶 On the contrary, Dodd-Frank regulated the financial markets to make another economic
crisis less likely. That's exactly what Glass-Steagall did after the 1929 stock market crash.

The main oeuvre

⮚ The Dodd-Frank Act makes the world safer in the following eight areas.
1. Oversee Wall Street:
🠶 The Financial Stability Oversight Council looks out for risks that affect the entire
financial industry. It also oversees non-bank financial firms like hedge funds.
🠶 It will recommend that the Federal Reserve supervise any that gets too big. The Fed will
ask it to increase its reserve requirement. This prevents another AIG from becoming too
big to fail. The Council is chaired by the Treasury Secretary, and has nine members: the
Fed, SEC, CFTC, OCC, FDIC, FHFA and the new CFPA.

2. Stop Banks from Gambling with Depositors' Money:

🠶 The Volcker Rule bans banks from using or owning hedge funds for the banks' own profit.
That's because they'd often use their depositors' funds to do so.
🠶 Banks can use hedge funds for their customers only. Determining which funds are for the
 banks' profits and which funds are for customers has been difficult.
🠶 Therefore, Dodd-Frank gave banks seven years to divest the funds. They can keep any
funds if that are less than 3% of revenue. Banks lobbied hard against the rule, delaying its
approval December 2013. It went into effect in April 2014, and they had until July 21,
2015, to implement it.

3. Regulate Risky Derivatives:

🠶 Dodd-Frank required that the riskiest derivatives, like credit default swaps, be regulated
by the Securities Exchange Commission (SEC) or the Commodity Futures Trading
Commission (CFTC).
🠶 In this way, excessive risk-taking can be identified and brought to policy-makers'
attention before a major crisis occurs. A clearinghouse, similar to the stock exchange,
must be set up so these derivative trades can be transacted in public.
🠶 However, Dodd-Frank left it up to the regulators to determine exactly the best way to put
this into place, which led to a series of studies and international negotiations.

4. Bring Hedge Funds Trades Into the Light:

🠶 One of the causes of the 2008 financial crisis was that, since hedge funds and
other financial advisors weren't regulated, there was no information on their
investments. That's why the Fed and other agencies thought the sub-prime mortgage
crisis would be confined to the housing industry.
🠶 To correct for that, Dodd-Frank says that hedge funds must register with the SEC and
provide data about their trades and portfolios so the SEC can assess overall market risk.
States are given more power to regulate investment advisers, since Dodd-Frank raises
the asset threshold limit from $30 million to $100 million.

5. Oversee Credit Rating Agencies:

🠶 Dodd-Frank created an Office of Credit Ratings at the SEC to regulate credit ratings
agencies like Moody's and Standard & Poor’s.
🠶 Many blame the agencies for over-rating some bundles of derivatives and
mortgage-backed securities. This misleads investors who didn't realize the debt was in
danger of not being repaid. The SEC can require agencies to submit their methodologies
for review, and can deregister an agency that gives faulty ratings.

6. Regulate Credit Cards, Loans, and Mortgages:

🠶 The Consumer Financial Protection Bureau consolidated the functions of many different
agencies.
🠶 It oversees credit reporting agencies, credit and debit cards, as well as payday
and consumer loans (but not auto loans from dealers).
🠶 The CFPB regulates credit fees (credit, debit, mortgage underwriting & bank fees).
🠶 It protects homeowners in real estate transactions by requiring they understand risky
mortgage loans. It also requires banks to verify borrower's income, credit history and job
status. The CFPB is under the U.S. Treasury Department.

7. Increase Supervision of Insurance Companies:

It created a new Federal Insurance Office (FIO) under the Treasury Department, which
identifies insurance companies like AIG that create a risk to the entire system. It also
gathers information about the insurance industry and make sure affordable insurance is
 available to minorities and other underserved communities. It represents the U.S. on
insurance policies in international affairs. The new office also works with the states to
streamline regulation of surplus lines insurance and reinsurance.

8. Reform the Federal Reserve:

The Government Accountability Office (GAO) was allowed to audit the Fed's emergency
loans during the financial crisis. It can review future emergency loans when needed. The
Fed cannot make an emergency loan to a single entity, like Bear Stearns or AIG, without
Treasury Department approval. (Although the Fed did work closely with the Treasury
during the crisis.) The Fed must make public the names of banks that received these loans
or TARP funds.

The debate over the Dodd-Frank financial regulations (2010)

There is an extensive debate on the financial regulatory act, focusing on the following most
common 3 questions among experts:

1st question: What does it mean to end bailouts and Too Big To Fail?

🠶 Bailouts in periods of financial crisis appear to be unfair because they play by special
rules that only go into effect when a bank is already about to fail and are decided on a
case-by-case situation. Bailouts prevent those who stand to gain the most in good times
from also losing the most in bad times. Hank Paulson’s original request for bailout money
without strings attached, in a three-page bill no less, remains one of the bailouts most
unpopular legacies.
🠶 Yet the dangers of unaddressed financial crises are real. This kind of systemic risk is
contagious, where failures at one business spread to everyone. One example of this is
bank runs, where the failure of one bank makes everyone rush to pull their money out of
other banks. A “shadow banking run,” happened in the capital markets and on Wall Street
during the latest crisis.
🠶 Dodd-Frank tries to deal with these issues by creating the rules for a crisis in advance. It
requires stricter regulations on capital and activities for the largest and riskiest financial
firms, to make them less likely to fail in a crisis. Dodd-Frank also grants the FDIC a special
new power called resolution authority. This allows the government to run a bridge
company to keep essential operations running at a failed firm that needs to be liquidated,
with losses put on those who deserve them, rather than putting taxpayers at risk.
🠶 So what do critics have to say? The first objection is that all of this is unnecessary –
there’s no such thing as systemic risk. Bank runs usually don’t happen, but when they do
they are necessary, and they don't threaten the surrounding financial system. This
laissez-faire approach doesn’t carry much weight among scholars.
🠶 The second criticism (from Hensarling) is that resolution authority is a permanent, unfair
bailout. Some argue that the FDIC will use their powers to bailout creditors instead of
imposing losses on them. Others worry that the FDIC’s ability to borrow money and
provide bridge money is an unfair practice that puts taxpayers at risk of losses. The
underlying concern is that stakeholders in the financial firm won’t care if they go through
resolution authority, and as such, resolution authority makes them a safer bet and acts as
a kind of permanent bailout promise to the markets.
🠶 The third criticism is that this isn’t a credible threat because the largest financial firms are
too risky, too complex, too international and contain too much political clout for these
painful measures to be tried. This criticism is where people look to change what
Dodd-Frank does, either through an expansion or limitation.
 2nd question:Does Dodd-Frank do too little, or too much?
🠶 Here is where breaking up the banks, either along business lines and or in size, comes into
play. Senator Sherrod Brown and former Senator Ted Kaufmann proposed an
amendment designed to break up the banks during Dodd-Frank, with a cap on the
amount of non-deposit liabilities at 3 percent of GDP.
🠶 This is no longer accurate, as the biggest firms are now even bigger. Brown is now
teaming up with Senator David Vitter (R-La.) to propose a similar law to break up the
banks, an idea that is gaining in popularity.
🠶 Another area that many feel needs additional reform is the treatment of short-term
creditors and other panic-prone sectors like the money market mutual funds. Regulators,
through the Financial Stability Oversight Council, are trying to lead where the SEC has
been unsuccessful.
🠶 But there are those who feel Dodd-Frank goes too far. William C. Dudley, president of the
Federal Reserve Bank of New York, argues that Dodd-Frank took away too much of the
ability to lend in an emergency through the Federal Reserve’s special powers.
🠶 This is an important debate. There was a lot of time and energy that went into rewriting
these emergency lending powers during Dodd-Frank. The final rule that the Senate came
up with was to allow the Federal Reserve to lend only “for the purpose of providing
liquidity to the financial system, and not to aid a failing financial company." Further, it
can’t lend to borrowers it believes are insolvent.
🠶 Others have argued that if resolution authority works and we can impose losses on
financial firms, we don’t need any additional regulations, and can start pulling back on
reform like the Volcker Rule or new rules on derivatives. This is the equivalent of saying
that since cars now have air bags, we don’t need to have speed limits, stop signs, or any
other traffic laws. The failure of a major firm is still risky enough to have a significant
market impact, and having multiple rules to reinforce each other is smarter than relying
on just one, risky rule.
🠶 One popular way of requiring the financial sector to be less risky is for banks to hold
more capital. But what form should it take?

3rd question: How much extra capital should banks hold, and what should it look like?
🠶 Even with the new Basel requirements, many experts are worried that banks will remain
under-capitalized going forward. In “The Bankers New Clothes,” Anat Admati and Martin
Hellwig say that banks should hold more equity. They argue that banks’ equity should be
on the order of 20-30% of their total assets. The Systemic Risk Council, calls for raising
equity a bit more modestly, to 8 percent.
🠶 Others think that we should instead require banks to hold special types of debt. A
long-standing argument is that banks should hold debt that converts into equity
contingent on whether or not they are in crisis (aka “coco” bonds). Many others argue
that a market trigger, like a CDS, could be used to convert these debts, though this
approach assumes deep, transparent, liquid markets that aren’t susceptible to
manipulation. Admati and Hellwig refer to this second approach as the “anything but
equity” approach. Instruments like coco bonds could cause additional turmoil and death
spirals at companies. Meanwhile, the implementation and triggering of such instruments
poses additional regulatory problems that equity does not. In response, others argue that
high levels of equity will be way too expensive for banks relative to these instruments.
🠶 Notice how these debates go together. Financial institutions that are more siloed, better
regulated and have a significant amount of first-loss capital will be easier to put into resolution,
and thus end Too Big To Fail. There will not be a silver bullet here – there will instead be a series
of strong regulations that reinforce each other, or weak ones that undermine others.

THE BACK BONE OF THE PRESENTED CRITICISM ON DODD –FRANK ACT

The bottom line is that Dodd-Frank didn't end too big to fail, Besides, "Dodd-Frank
institutionalized and codified too big to fail."
 Classical Version of Lender of Last Resort Facility (LOLR) and relevant critical
analysis

Time Evolution of the definition of LOLR

★ Francis Baring used the term “Dernier Resort” in 1797, by introducing the notion of the
Bank of England as the “Last Resort” of the Banking System. The concept was soon,
thereafter developed, very substantially, by Henry Thornton in 1870.
★ The historical and theoretical basis of lender of last resort assistance was originally
developed by Henry Thornton in the early 19th century and then by Walter Bagehot
some 70 years later. Both authors used the term “lender of last resort” in their writings,
and this is still widely used at the present time.
★ Other terms such as “emergency liquidity assistance” and “emergency liquidity
financing” are also used. Since it is becoming increasingly difficult to ascertain what
constitutes LOLR, it is useful to go back to the origins of the doctrine first and to establish
then how much we have departed from that traditional doctrine (or from “good practice”)
★ Finally, Freixas et al. (2002) provide the following description of the use of lender of last
resort in modern times: “The discretionary provision of liquidity to a financial
institution (or the market as a whole) by the central bank in reaction to an adverse
shock which causes an abnormal increase in demand for liquidity which cannot be met
from an alternative source”.

Problems & the financial safety net

PROBLEMS FINANCIAL SAFETY NET

► Externalities ► Lender of Last Resort

► Sensitivity in systemic liquidity shortage ► Deposits Guarantee System
► Banks interconnection ► Prudential supervision

REGULATORY INTERVENTION IN TERMS OF TERMINATION AUTHORITY

Financial safety net : LOLR-ELA vs EFSF
★ The LOLR is one of the main components of the banking Safety Net.
★ Only Central banks can provide legal tender and the asset with the highest liquidity.
★ Central banks have the monopoly to create the “last” money. In fact, classic LOLR, in
the sense that we have traced the term from Francis Baring, is the provision of
liquidity, and that can only be done by a central bank.
★ Central banks act as LOLR, when determined that the Credit Institutions, face
temporary liquidity problems ( dealing with ‘funding (or liability) liquidity risk’ and not
‘market (or asset) liquidity risk’), and not solvency ones, in order to prevent its
conversion into solvency problems. When private banks in panic do not lend to each
other and there is a systemic liquidity shortage, Central banks must start lending to
institutions in need to prevent the collapse of the financial system.
★ ELA (Emergency Liquidity Assistance): Is the Eurozone’s LOLR.
★ The term “lender of last resort” evokes collateralized lines of lending, while emergency
liquidity assistance encompasses a broader array of operations.
★ The European Financial Stability Fund (EFSF): responsible for addressing solvency
issues
Function of classic LOLR role
● The classic role of LOLR should be guided by the following four main principles, or in
accordance with the essence of the theoretical basis is that there are four “pillars,” or
conditions, that are to be applied when providing lender of last resort assistance. These
 are not legal principles, but rather principles attributed to LOLR since the doctrinal
elaboration by Thornton and Bagehot:

Main principles of classic LOLR role

1. It should lend freely, that is it should lend as much as is needed.
2. The rate of interest charged should be high. It should lend at a penalty rate, in order to
reduce moral hazard as the existence of a lender of last resort can lead to risky lending
in the hope of privatizing profits and socializing losses. According to Bagehot, these
loans should only be made at “a very high rate of interest” and went on to say that “this
will operate as a heavy fine on unreasonable timidity and will prevent the greatest
number of applications by persons who do not require it. Thus, it was clearly the
intention of Bagehot that the availability of this sort of financing was to be at a price
significantly greater than that being charged by other lenders to ensure that recourse
to such assistance would only be made after all other avenues had been tried.
3. The third pillar is that the central bank should lend to any actors with good collateral.
It should accommodate anyone, who can provide “good” collateral which is valued at
lower than pre panic prices but higher than it would have been valued had the central
bank not entered the market.
4. It should lend to illiquid but not to insolvent institutions to stem a crisis which could
lead to the failure of a bank or banks.

MORAL HAZARD
● The moral hazard reduces market discipline, arising from the fact that when commercial
banks are aware of and confident that they will be refinanced in the aftermath of a
crisis. Consequently, their motivation for prudent management decreases.
● In order to avoid it, a Central bank would have the formal right not to lend. However,
economic costs of such a policy would be high and the
● CB would fail to provide the public good of a stable financial system. In any case, the
absence of the Central Bank's explicit commitment to act as lender of last resort, could
be described as a deliberate constructive ambiguity, as having. neither at national nor at
EU level, statutory/regulatory basis.

CONSTRUCTIVE AMBIGUITY
● According to Campbell, A.& Lastra R, 2009, the constructive ambiguity can be considered as
the fifth principle/pillar of the classic LOLR, but they describe it in a slightly different
way. They wrote that while the central bank should let it be known in advance that it
will be ready to lend, it will also exercise discretion in whether to help. This is
sometimes referred to as “constructive ambiguity,” although as will become apparent,
neither author agrees that this is a constructive feature and indeed, they believe that
often “destructive” would be a more appropriate term to use; hence their preference
for the word “discretion”: the central bank’s LOLR role is discretionary, not mandatory.

Revised Version of Lender of Last Resort Facility (LOLR) and relevant critical
analysis

The revised role of LOLR during the recent period of great recession

● LOLR/ ELA operations have acquired a new significance in times of crises, leading to
remarkable changes in Europe and elsewhere.
● The operation of the classic Lender of Last Resort (LOLR) in times of financial crisis
should be amended accordingly, in order to activate the role LOLR function in a more
 effective manner, to protect the banking system, and to support the economy. On this
basis, are proposed the following changes, which in some cases have already been
adopted, directly or indirectly, by the relevant supervisory bodies:

1. It should lend at a low interest rate:

If only one bank has liquidity problems and there is no systemic crisis, a high interest rate
policy is fine. However, during a financial crisis, high interest rates intensify systemic risk
further; given that they are not only a burden for commercial banks, but they also increase the
cash-flow problem for non-bank financial institutions, the enterprise sector, and for indebted
private and public households. Consequently, high interest rates can push economic units from
a liquidity crisis into a solvency one. Low interest rates are needed during a crisis. Here we can
refer to both reductions in the discount rate of the FED and the ECB, acting as indirect lenders
of last resort and the adoption, initially, by the FED and recently by the ECB of the quantitative
easing program without liquidity sterilization.

Thus, in times of deep economic recession, the Moral hazard has to be solved by financial
market regulation and the threat of losing property. “Liquidity provision should be performed by a
Central bank; the governance of moral hazard by another institution, the supervisor” Such a role
could be played by the ECB through the «Single Supervisory Mechanism'' (SSM). Bentral banks
and the relevant supervisory authorities should, apriori ( during economic growth), have
enforced with the necessary regulatory framework the Banking System in order to be able to
overcome the arising difficulties in crisis and economic recession periods.

2. It should, not necessarily, lend only to illiquid but not to insolvent institutions:
Normally, as LOLR, the CB should address illiquid but not insolvent institutions. behind this
idea hides the doctrine that insolvent financial institutions should not be saved by the Central
bank. In principle, this doctrine is correct. Really, there is no need to save bankrupt financial
institutions.
However, a Central bank cannot easily distinguish between financial institutions with
solvency problems and others with liquidity problems. The immediacy of the need for
assistance makes it difficult to assess at the moment whether the institution is illiquid or
insolvent. Moreover, during a severe financial crisis, a bank can be insolvent simply because its
assets are temporarily valued at fairly low prices. So, we can say that a systemic liquidity crisis
can easily be combined with or lead to a systemic insolvency crisis.
In the latter case there are cases where the CB should finance insolvent institutions,
but without rescuing the owner. Lending to insolvent institutions is a departure from the
classical LOLR principles. But it is indispensable, because if central banks provide inadequately
collateralized support to insolvent institutions, the traditional short-term nature of the LOLR
assistance is likely to be insufficient. Consequently, the LOLR, will be the first link in a chain or
process that is likely to include a bank insolvency proceeding.
In the EU, there is a need to comply with state aid rules, due to the fact that an inherent
subsidy exists whenever the central bank lends to an insolvent institution. Under the EC rules
on state aid, the granting of aid to banking institutions could be considered illegal in some
times. Moreover the risk of loss to the central bank is ultimately a risk of loss to the public (i.e.
taxpayers).

3. It should, not necessarily, lend to actors with good collateral:

The 3rd principle of the classical LOLR is difficult to fulfill during a systemic financial crisis, due
to the fact that good collateral quickly becomes bad collateral when asset prices erode
(securitization problems, haircuts etc). Thus, we can say that the new role of LOLR is implicitly
interwoven with the risk of «market (or asset) liquidity risk».
The revised role of LOLR during the recent period of great recession (3b)

Sometimes insolvent institutions get assistance in times of crises. In these cases, the problem
will be solved with limited ST lending~ support in the form of “rescue aid” that must be
temporary and reversible ( not exceeding six months).
Here we observe another departure from the classical LOLR principles. That of “Lend freely”,
unless the “rescue aid” is converted into “restructuring aid” through the submission of a
“restructuring plan” of "rescue aid." Examples: the cases of the Hellenic Financial Stability Fund
(national level) and Resolution Mechanism (Single Resolution Mechanism - SRM - at the
eurozone level, which is the second pillar of the European Banking Union). we can say that in
turmoil periods, the role of LOLR, as "Crisis Lender", which offers "rescue aid:", converts into
"Crisis Manager" by providing restructuring aid: "

How then, will it avoid the arising, described in the previous transparency moral hazard?
According to Fischer, there is a clear distinction between'' Crisis Lender "and" Crisis Manager “,
given that the former (Lender), is the role of the Classic LOLR and such a role of providing
liquidity to the commercial banks and credit institutions, must be played by:
a) the national central banks
b) the ECB and the FED (see, for example, ELA-Quantitative Easing).
Whereas, the latter is relying on the revised LOLR, in a more integrated form. Sometimes a
Crisis Manager does lend, but this action need not be with the aim of providing liquidity.
Therefore, a Crisis Manager can manage, without lending. But in this case, it couldn’t be a
LOLR, even the revised one. The best definition of the Crisis Manager role is that it can supply
capital and not provide liquidity. This act can be done by the IMF and EFSF. Additionally, the
integrated responsibilities of the crisis manager should include those of the assessment –
evaluation (like the role of ECB in the case of ELA) and consultancy. Furthermore, LOLR as a
crisis management instrument has always been related to other crisis management
procedures, notably deposit insurance and insolvency proceedings.

What about the existence of the constructive ambiguity in the performance of the revised
role of LOLR?
The concept of constructive ambiguity has been altered in response to the financial crisis. In
times of extreme uncertainty and volatility, market participants want little ambiguity from
their central bank. If that were to happen, there would be no place for ambiguity, constructive
or otherwise, and providing the collateral requirements are satisfied, the role of a Central Bank
would not be to decide whether or not to assist, but simply to evaluate the quality of the
security being offered and then to provide assistance.
In addition, it should be noted that at the European Central Bank level (ECB), in other words,
at a european or in accordance to Fischer’s writings at an International LOLR level (because
and International LOLR, can help mitigate the effects of the current crisis instability and
perhaps the instability itself), the principle of constructive ambiguity, inactivated, since the
ECB is, by its nature, always a strict regulator.

In what way, the new philosophy of Constructive Ambiguity affects the second fundamental
component(i.e. the Moral Hazard) of LOLR?
The downside of “protection” is moral hazard. In the absence of protection, individuals and
institutions tend to be more conservative and less risk prone. In this regard, despite the change
of the classic sense of constructive ambiguity and the fact that disclosure is generally a good
thing, given the psychological component in the rapid spread of a crisis,the provision of covert
as opposed to over assistance should remain in the arsenal of the central bank.
Concluding observations

During a financial crisis a central bank should lend comprehensively at low interest
rates. It should also accept poor collateral, and save systemic,relevant institutions even if these
are insolvent, however, the owners of such institutions should not be rescued.
Reputation and confidence are and were at the core of what LOLR/ELA operations aim
to achieve. In this sense, the revision of the traditional principles ought to mitigate the issues of
“stigma” (resulting from a perception that only the desperate go to the LOLR/ELA).
Central banks and public authorities can claim that if they are to assist an institution in
“a rainy day” they should regulate that institution in “a sunny day.” Hence, regulation and
protection tend to be mutually reinforcing.
The importance of a clear mandate and a set of enabling rules for the central bank with
regard to financial stability, in particular with regard to its LOLR/ELA operations contributes
positively to the safeguard of confidence and has a positive reputational effect.
A great dilemma arises: efficiency versus stability in the financial /banking system.
When we have an effective banking system these rules are ineffective, on the other hand when
the system is crisis prone the relevant legislative framework is stable. This dilemma resembles
another great one that can be found in the field of regional science: efficiency versus equity.
The longer a crisis lasts the more severe its effects are. “At the end of the tunnel of a
financial crisis lies not light,but the gloom of recession. As surely as smoke follows fire, what
comes after a financial meltdown is an economic downturn”. The repair of the financial system
is a major priority for governments around the World.
All the proposing reforms could contribute to a more effective and efficient function of
the LOLR, provided that they will be combined with the appropriate reforms and restructuring
strategies of the Banking and generally financial system