Current Developments in Monetary and Financial Law, Vol. 3
Chapter

CHAPTER 23 Emergency Liquidity Financing by Central Banks: Systemic Protection or Bank Bailout?

Author(s):
International Monetary Fund
Published Date:
April 2005
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Author(s)
ROSS S. DELSTON and ANDREW CAMPBELL

The aim of this chapter1 is to consider the ways in which emergency liquidity funding (ELF) may be provided by central banks2 to individual banks that are experiencing financial difficulties. ELF takes the form of loans from, or guarantees by, the central bank that are designed to assist one or more commercial banks that are either undergoing a run on deposits as a result of concerns about safety and soundness or that are experiencing a systemic financial crisis.3

For the purposes of this paper, ELF includes, and is largely synonymous with, the term “lender of last resort” (LOLR) financing. Although the term LOLR is widely used internationally and much has been written about it, in our view, ELF more accurately describes what actually takes place. Sir Edward George, the former Governor of the Bank of England, has noted that the term LOLR can be confusing, and he states that the role of the central bank is not to prevent each and every bank from failing and that it is necessary for the maintenance of the health of the banking system that there be a possibility of bank failure.4 This chapter will examine the practical realities of the provision of ELF, since although much has been written on this subject, what actually happens in practice is typically not discussed.

By way of background, the fundamental principles of this type of assistance are relevant. First, ELF should be given by the central bank only to banks that are illiquid and not insolvent. Second, the loan or other financing should be subject to a penalty rate of interest. Third, collateral (or security) should be provided.5 Fourth, its use must be discretionary, and there should be no expectation that such help will be available.6 It has been described as “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 that causes an abnormal increase in demand for liquidity which cannot be met from an alternative source.”7

Historically, banks have been the only type of institution that have had access to ELF from central banks. Other types of financial institutions have not been able to turn to the central bank for this type of assistance in times of crisis. Banks are considered to be a special case, and the reasons why banks are considered to be different are discussed below. For the purposes of this chapter, the term “bank” has the same definition as that of “credit institution” as found in the European Commission Consolidated Banking Directive, under which a credit institution is “an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account.”8 It is normal practice internationally that institutions that fit within this description will be treated as banks and be potentially in a position to receive ELF should the need arise.

Why Do Banks Request ELF?9

Typically, banks request ELF from a central bank in response to a run on deposits. What exactly is a run? On an accounting basis, a run is a symptom of illiquidity, which means in the banking context that the long-term assets of the bank, generally loans, are not able to be liquidated fast enough to pay the bank’s short-term liabilities, mainly deposits. As a result, the bank quickly runs out of cash and, assuming that other banks will not lend, must turn to the central bank. This goes to the very heart of the need for a provider of ELF. Banks are different from other types of organizations. They operate on the basis of fractional reserves and are therefore susceptible to runs and panics. What this means is that at any time a bank will keep only a relatively small percentage of its assets in the form of cash. The remainder will be in the form of loans and other assets that cannot normally be converted immediately into cash. How much cash will be held at any time will depend on a number of factors, such as the anticipated level of withdrawals and deposits and also the legal and regulatory requirements in the particular jurisdiction in which the bank is operating. Despite this, in most jurisdictions depositors will normally be legally entitled to withdraw a significant percentage of their savings on demand. This mismatch, sometimes referred to as “maturity transformation,” is always a source of risk that can never be totally eradicated.

In theory then, when a bank is illiquid prior to, or as a result of, a depositor run, the bank is not necessarily insolvent on a book basis,10 since it may simply be experiencing a short-term inability to liquidate long-term assets to pay short-term liabilities. This produces an assetliability mismatch. In practice, however, experience shows that it is rare indeed to find a bank experiencing a run that is not subsequently found to be insolvent.

In other words, in practice, illiquidity almost always means insolvency. In almost every case, once a depositor run is in full sway, and banking regulators or external auditors examine the bank on an emergency basis, the bank is found to be insolvent on a book basis, that is, its assets (primarily loans) are less than its liabilities (primarily deposits). In a number of crisis countries in the late 1990s external auditors (who are typically not the auditors who were previously associated with the bank) were brought in to examine insolvent banks to determine the extent of the losses. It was typical in those cases not only for the banks to have been found to have been insolvent, but also to have found that the losses exceeded everyone’s expectations, including the regulators’.

It should be noted that under many bankruptcy laws around the world, illiquidity, typically defined in bankruptcy law as the “inability to pay debts as they become due,” is one of the grounds for the appointment of a bankruptcy receiver.11 This test is also one of the grounds for closure of a bank or license revocation under a number of banking laws, including those of the United States. The adoption by countries of a ground such as this could mitigate or limit the need to provide ELF.

Representative Statutory Provisions

It is, in our view, good practice to have the basis of ELF set out explicitly in the law of the country, preferably in statutory form, rather than to have some sort of implicit arrangement in place. Our research of actual practice in a number of countries indicates that the approach taken to the provision of ELF varies considerably from country to country.12

Many of the laws contain a requirement that when a bank is receiving ELF, collateral must be provided, but what constitutes eligible collateral varies among jurisdictions.13 Such collateral may take a number of forms, for example, gold, foreign currency, or government paper. Some jurisdictions permit unsecured ELF by the central bank,14 and some jurisdictions have provisions that allow such financial assistance to be either secured or unsecured.15 Some laws may contain limitations on the size of the ELF as well as requirements as to the time period of the funding,16 the repayment terms, and interest rates.

There may also be a requirement in the law that the borrowing bank be solvent—either as a matter of law or of policy. Where this requirement is contained in law, it may raise concerns based on the fact that in most cases banks undergoing runs are subsequently discovered also to be insolvent on a book basis. Hence, if such a provision were a condition of ELF as a matter of law, since most central banks typically are predisposed to providing ELF, and, at the time of providing ELF are not in a position to know definitively whether the bank is in fact solvent, the central bank typically would proceed with ELF. Once a subsequent finding is made that the bank is insolvent, the central bank may be stymied. How can it revoke the bank’s license or otherwise close the bank since it has just made a finding of solvency? This is not a theoretical issue but has been a practical concern in at least one country, with the unwanted result that regulators have kept insolvent banks open for long periods instead of revoking the licenses and liquidating the banks. Hence, statutory requirements of solvency are best avoided. A far better approach is to have a policy that ELF will not be available to insolvent banks.

The legal provisions of ELF do not usually contain a requirement that the borrowing bank be subject to an immediate examination; conservatorship or provisional administration; or remedial measures such as directives, administrative fines or civil money penalties, conditions on license, or license revocation.

United States

The United States has a complex and difficult approach to the issue, with two separate and distinct ELF provisions. The first authorizes the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) to prescribe regulations under which Federal Reserve banks, such as the New York Fed, may provide loans (called advances in the legislation) to member banks for up to four months with appropriate security.17 Note that under U.S. law, the use of the “discount window,” as it is often called, is the same regardless of whether the liquidity financing is on an emergency basis or not; however, there are a number of restrictions that apply to banks that do not have adequate capital. Advances to an undercapitalized member bank are restricted in that any advances may not be outstanding for more than 60 days in any 120-day period.18

There are two exceptions to this restriction. First, the restriction may be suspended for one or more 60-day periods if, for each 60-day period, the head of the appropriate Federal banking agency19 certifies in writing to the Federal Reserve bank that the borrowing bank is viable, or the Chairman of the Federal Reserve Board certifies to the Federal Reserve bank that the borrowing bank is viable after the Board has conducted an examination.20 Second, in the absence of any such certification, with respect to critically undercapitalized banks,21 the Board may make advances not subject to the 60-day rule, but the Board will then be liable to the Federal Deposit Insurance Corporation (FDIC) in the event of the failure of the bank for any losses in excess of what would have occurred without the advances.22 Hence, these provisions attempt to limit the central bank’s ability to provide ELF to insolvent banks, with the ultimate penalty for the central bank—that it will become liable for losses to the FDIC if it continues to make ELF available to critically undercapitalized banks.

There is also a second type of ELF in the United States that is available from the FDIC as insurer of deposits up to $100,000, not just to banks that are members of the Federal Reserve System, but also to a broader array of insured depository institutions (IDIs), independent of that described above. The FDIC may provide financial assistance, including loans or other types of financing, in three cases: (1) to an IDI that is insolvent or in danger of becoming insolvent to restore it to normal operation, (2) “when severe conditions exist which threaten the stability of a significant number” of IDIs or of IDIs “possessing significant financial resources,” or (3) “to facilitate a merger or consolidation” of an insolvent IDI with another IDI.23 In order to provide this assistance, the FDIC must first make a determination that such assistance is necessary to meet its obligations to provide deposit insurance for the bank’s depositors and that such assistance would be the least costly method of meeting this insurance obligation.24

Because the “least cost test” is so stringent, there is an exemption in cases of systemic risk. In order to avoid “serious adverse effects on economic conditions or financial stability,” the requirement of least cost resolution may be suspended by the Secretary of the Treasury, in consultation with the President of the United States, upon a written recommendation approved by two-thirds of the board members of both the FDIC and the Federal Reserve Board.25 Any losses to the deposit insurance fund are to be repaid by an emergency special assessment on the members of the deposit insurance fund.26 Hence, for banks that are “too big to fail” because their failure would result in systemic harm, ELF is available with the signature of the top financial officials in the United States.

United Kingdom

While in many countries, including the United States, ELF is clearly defined by law, this is not always the case. The United Kingdom provides an example where the approach taken is radically different. Traditionally, the Bank of England has been the provider of ELF to U.K. banks, but this has never been set out in law. The Financial Services and Markets Act 200027 is the main piece of legislation in the United Kingdom pertaining to the regulation of banking, but it is silent as to the provision of ELF. Under the Bank of England Act 1998, the Bank of England is responsible for U.K. monetary policy and no longer has responsibility as regulator of the banks in the United Kingdom.

Instead, the approach taken is to rely on a Memorandum of Understanding among the Financial Services Authority, the Bank of England, and Her Majesty’s Treasury that sets out the framework for cooperation among the three bodies.28 The Memorandum gives the Bank of England responsibility for the overall stability of the banking system. For banks experiencing financial difficulties, the Bank is to undertake official financial operations in exceptional circumstances “to limit the risk of problems in or affecting particular institutions spreading to other parts of the financial system.” No legal authority is cited in the Memorandum and no guidance is provided as to the operation of ELF.29

Fortunately, the former Governor of the Bank of England, Sir Edward George, has provided guidance on the approach to be taken by the Bank with regard to the provision of ELF.30 George emphasizes that the provision of ELF is discretionary and that the Bank of England should not be predictable in its decisions to approve or refuse support. He notes also that the decision is often to withhold support and this is likely to be the case when there is no perceived risk to the financial system generally.31 Although the lack of formal statutory powers may not be an impediment to the effective provision of ELF in the United Kingdom, it is not, in our opinion, an approach that should be followed in other jurisdictions.

Illegal State Assistance: The Case of the European Union

The question of the legality of providing ELF can be quite complicated when it may be in conflict with other legal provisions. For example, within the European Union the granting of State aid in certain circumstances may be illegal as it may distort competition.32 It is important to appreciate that not all State aid is prohibited, but the provision of such financial assistance is legal only where strict conditions have been satisfied and where the European Community guidelines are followed. This means that it is permissible for central banks in member states of the European Union to provide financial assistance to a financially troubled bank only when this would not breach these conditions. It appears to be the case that the provision of ELF is not likely to constitute a breach of EU law, provided that the financial assistance is of a strictly temporary nature and is to be fully repaid with an appropriate rate of interest. In fact, the European Commission has indicated that it “will take into account the peculiarities of the banking sector as well as the sensitivity of the financial markets”33 when deciding whether State aid is justified, thereby indicating that ELF, when properly applied, would be legal. European central banks will therefore have to be particularly careful when considering the provision of ELF.

ELF in a Systemic Crisis

The role played by the central bank is different in a systemic crisis. One of the first problems encountered is attempting to define what constitutes a systemic crisis. Put simply, it is the risk that the failure of one financial institution will have a domino effect and lead to financial problems spreading throughout the banking system. Exactly when a crisis becomes systemic is not something about which there is any international agreement, and it will usually not be something that is set out clearly in the law but rather calls for more of a value judgment that must made in a hurry.34 Typically, in a systemic banking crisis, all banks that require assistance will receive funding (be bailed out), and any usual collateral requirements will be ignored in the interest of saving the banking system. In this situation it would normally be unrealistic to require any collateral.

Coordination among the central bank, the banking supervisor, and the Ministry of Finance is needed, and although this is not always required by law, it will often take place on an informal basis. This can be potentially problematic, and in many countries the central bank will be reluctant to act unless its powers and duties are clearly set out in law, and ideally in the form of a carefully drafted statute. It could be argued that because the amount of ELF needed in a systemic crisis is so large, and the macroeconomic implications are so significant, this should be a State obligation rather than a central bank obligation. Much depends on the political situation in the individual country, but it is easy to see why a central bank might be wary of committing such a huge amount of public funds without government backing.

Another matter of significance and something that central bank Governors should be concerned about is that postmortem investigations by the executive, legislative, or judicial branches of central bank activities during the crisis are becoming more common.

Observed Responses to ELF Requests by Central Banks: Unforeseen but Foreseeable Consequences

When central banks provide ELF without adequate security, or with a pledge of assets by the illiquid bank that are sufficient based on book value but not on market value, the potential exists for the financing not to be repaid when the bank fails.

This possibility has at least two outcomes, both of which are undesirable. The first is that the central bank becomes the largest creditor of the bank, since it has replaced deposits with ELF. The nonpayment of this financing can result in a charge against the capital of the central bank. Given enough such financing or a large enough bank receiving it, central banks themselves may become insolvent. At the very least, a significant conflict of interest is created when the central bank, as regulator, becomes a major creditor of a regulated entity. The second possible outcome is that the central bank or banking regulator decides not to close the bank, since to do so would result in nonpayment of the financing. Hence, banks may be kept open that would (or should) otherwise be closed.

It is an article of faith among central bankers that ELF should not be provided to insolvent banks, but only to those experiencing short-term liquidity shortfalls. However, this policy (sometimes required by law) presumes that banks undergoing depositor runs will not be found to be insolvent later. If, in fact, the presumption were to be reversed so that such banks were presumed to be insolvent, then ELF would be provided, if at all, only to banks that are considered to be “too big to fail.” At the very least, this would eliminate the need to fund the myriad smaller, nonessential banks that typically receive such financing. While the concept of “too big to fail” is a controversial one, in every country that has had a systemic bank crisis in recent years there have been banks considered too big or too essential to be allowed to close, and therefore the relevant authorities (central banks, Ministers of Finance, financial regulators, and/or heads of State) have acted in some manner to prevent them from failing.

Model Law

A model statutory provision embodying many of the principles discussed in this chapter is attached hereto as Appendix III. The model provision has a number of features: first, ELF is limited to “exceptional circumstances involving systemic implications,” along the lines of U.S. law with respect to the systemic risk exception for ELF provided by the FDIC described above. Second, loans are limited to a period of six months. Third, the Minister of Finance and the central bank must each determine in writing that the ELF is necessary. This forces financial officials to work cooperatively.

Fourth, and most controversial, the State and not the central bank is liable for all such ELF, since it is provided only when there is systemic risk. This is perhaps the most controversial aspect of the model provision. Who should pay? While central bankers the world over might support having the government on the hook for ELF, it is not clear that this is always a good idea. After all, profit-sharing clauses in central bank laws are, at best, imperfect. The best evidence of this is the large number of central bank office buildings the world over that verge on the palatial, including fenced compounds that, in some cases, house other government agencies, museums, and other indications of stored value. Central banks are, after all, responsible for the health of the banking system, which may lead them to believe that their own financial health is a paramount concern. There is no easy answer to this question, but it is worth debating in the context of designing an ELF law.

Conclusion

The rules for providing ELF should be revisited, and the tilt toward providing financing for every bank experiencing a run should be addressed. At the same time, there should be sufficient flexibility in the law to allow a central bank to provide ELF on an unsecured basis when needed in a banking crisis. Central banks will do so regardless of the rules; therefore, the law should reflect the practical realities. In the case of a banking crisis, as provided in the model law, consideration should be given to having the state liable for ELF, since the health of an essential part of the economy is at stake.

Notes

While any mistakes are those of the authors, the assistance of the following is gratefully acknowledged: Stuart Yikona, Senior Research Officer, IMF; Parthasarathi Shome, Director, Singapore Training Institute, IMF; Tobias Asser, Legal Consultant (formerly Assistant General Counsel, IMF); and Peter Cartwright of the University of Nottingham, U.K.

In most countries it will be the central bank that has this responsibility, and it is generally thought that this is the most appropriate body to perform this function. In some jurisdictions other bodies may also have power. See, for example, the United States, where the Federal Deposit Insurance Corporation is given power to provide assistance, as described in detail below.

See generally, Dong He, “Emergency Liquidity Support Facilities,” IMF Working Paper WP/00/79 (2000), http://www.imf.org/external/pubs/cat/longres.cfm?sk=3542.0.

See E. George, “The Pursuit of Financial Stability” (1994) Bank of England Quarterly Bulletin, at 63.

This, in theory, should be on the basis of market rather than book value, which, at least for loan assets, will typically be inflated, but in reality this will often not be possible, and book value will have to suffice.

For readers who would like to read a detailed historical analysis, see W Bagehot, Lombard Street: A Description of the Money Market (Henry H.S. King & Co., London, 1873).

Freixas, Giannini, Hoggarth, and Soussa, “Lender of Last Resort: A Review of the Literature” (1999) 7 Financial Stability Review 1 (Bank of England, London). Available also on the Bank of England’s website at http://www.bankofengland.co.uk/fsr/fsr07art6.pdf.

Article 1(1), Directive 2000/12/EC, of the European Parliament and of the Council of 20 March 2000 relating to the taking up and pursuit of the business of credit institutions.

Much of this section and the section titled “Observed Responses to ELF Requests by Central Banks: Unforeseen but Forseeable Consequences” is based on a previous paper by R. Delston, “Five Observations About Failed Banks,” in International Monetary Fund, Current Developments in Monetary and Financial Law, Vol. 2 (IMF, Washington, D.C., 2003).

Referred to in many jurisdictions as “balance sheet test.”

See, e.g., section 123 (l)(e) of the Insolvency Act 1986 in the United Kingdom.

See Appendix III, which contains a chart with the statutory ELF provisions from 19 countries and see also the provisions of U.S. law on ELF in 12 U.S.C. Sec. 347b—Advances to Individual Member Banks on Time or Demand Notes; Maturities; Time Notes Secured by Mortgage Loans Covering One-to-Four Family Residences (Federal Reserve Board Provisions) and in 12 U.S.C. Sec. 1823—Corporation Monies; the first governing the Federal Reserve Board and the second governing the Federal Deposit Insurance Corporation.

E.g., Argentina, Bulgaria, and Lithuania.

E.g., Japan and the Kyrgyz Republic.

E.g., Botswana and Romania.

E.g., Chile, where the loan period is not to exceed 90 days but such loans can be renewed subject to certain conditions. The Kyrgyz Republic has a period of six months, but this can be prolonged by a decision of the Board of the Bank of the Kyrgyz Republic.

12 U.S.C. Sec. 347b(a).

12 U.S.C. Sec. 347b(b).

These agencies are the Office of Comptroller of the Currency for national banks, the Office of Thrift Supervision for savings associations, the Federal Reserve Board for State member banks (banks that are members of the Federal Reserve System), and the Federal Deposit Insurance Corporation for State nonmember banks. 12 U.S.C. Sec. 1813(q).

12 U.S.C. Sec. 347b(b)(2)(A) and (B).

This refers to those banks that are insolvent and therefore may be closed at any time by the appropriate Federal banking agency.

12 U.S.C. Sec. 347b(b)(2)(D) and (3).

12 U.S.C. Sec. 1823(c)(1).

12 U.S.C. Sec. 1823(c)(4)(A).

12 U.S.C. Sec. 1823(c)(4)(G).

12 U.S.C. Sec. 1823(c)(4)(G)(ii).

The Memorandum was issued by the Chancellor of the Exchequer on October 28, 1997. It is available at http://www.bankofengland.co.uk/legislation/mou.pdf. For a detailed account of the role of the Bank of England, see A. Campbell and R Cartwright, Banks in Crisis: The Legal Response (Burlington, VT, Ashgate, 2002) Chapter 3.

The partial text of the Memorandum may be found in Emergency Facilities, supra note 3, at 17, Box 3.

This is set out in full in E. George, supra note 4, at 60-66.

There were nine bank failures in the United Kingdom between 1987 and 1994 for which ELF was not provided by the Bank of England.

For a more detailed discussion of this, see A. Campbell and R Cartwright, supra note 28, at 62-66.

The Official Journal of Information and Notices 96/C 305/92.

Some commentators suggest that when more than 20 percent of the deposits in a banking system are affected, the crisis should be considered systemic. See, e.g., C. Dziobek and C. Pazarbasioglu, “Lessons from Systemic Restructuring: A Survey of 24 Countries,” IMF Working Paper, WP/97/161 (1998), http://www.imf.org/external/pubs/ft/issues/issues14/index.htm. Alan Greenspan has remarked that “…it would be useful to central banks to be able to measure systemic risk accurately, but its very definition is still somewhat unsettled. It is generally agreed that systemic risk represents a propensity for some sort of significant financial system disruption.” “Remarks at a Conference on Risk Measurement and Systemic Risk,” Board of Governors of the Federal Reserve System (New York, 1995), at 7.

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