Appendix II. Lender of Last Resort and Banking Crisis Management

Charles Enoch, and Tomás Baliño
Published Date:
September 1997
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Although currency boards during the colonial period were constrained from providing LOLR support, major commercial banks, which were foreign owned, could rely on their headquarters for liquidity support. By contrast, many banks operating in existing CBA countries are domestically owned.82

While the relaxation of high reserve requirements or liquidity requirements has helped release liquidity rapidly under emergency conditions, experience suggests that LOLR support is also needed to mitigate the effects of banking crises and restrict contagion. Indeed, banking crises have occurred in all CBA countries, except in the ECCB members, and all CBAs have explicit last-resort facilities (see Appendix IV, Table 2) except for Brunei Darussalam and Djibouti, whose banking systems are mostly or totally foreign owned.83 To comply with the backing rule, the scope for last resort support is limited to the foreign exchange reserves held in excess of the amount required for backing.84

In Argentina, the banking system experienced a large deposit run triggered by the Mexican crisis at the beginning of 1995. The crisis began with the closure of a small bank that was heavily exposed in Mexican assets and, hence, could not honor its obligations after the Mexican peso was devalued.85

As there was no explicit lender of last resort and the public feared that other banks could be similarly exposed, the closure of the bank triggered a chain reaction. Between the end of November 1994 and the end of May 1995, despite the rationing of bank deposit withdrawals at some banks, aggregate bank deposits declined by about 17 percent.86 Wholesale banks, small private and cooperative banks, and provincial and municipal banks were most heavily hit, with some banks losing more than 50 percent of their deposits.87

Most flight capital originated from time deposits, which were subject to relatively low reserve requirements, hence the automatic reduction in required reserves following the decline in deposits was minimal. To alleviate banks’ shortage of free reserves, the authorities responded by lowering unremunerated reserve requirements.88 Subsequently, banks were allowed to redenominate their settlement accounts and required reserves at the central bank in U.S. dollars. This added to credibility and reduced the CBA’s need for foreign exchange backing, as the latter extended only to peso-denominated liabilities. In March 1995, to facilitate the ongoing bank-restructuring program, banks were also allowed to fulfill up to half of their reserve requirements with cash-in-vault and assets purchased from problem banks.

To help resolve the banking crisis, the central bank’s charter was modified to allow the rollover of central bank rediscounts, collateralized advances, and swaps for a longer period and a larger amount.89

As a result, the stock of rediscounts increased from Arg$400 million (equivalent to 3 percent of reserve money) in February 1995 to a peak of around Arg$ 1,800 million (equivalent to 12 percent of reserve money) in July 1995. In addition, a special facility for distressed banks was established. The facility was administered by the Banco de la Nacion Argentina, a state-owned bank, and financed by 2 percent of banks’ required reserves.

Several banks in financial difficulty were suspended, and the Bank Capitalization Trust Fund and the Trust Fund for Provincial Bank Privatization were established to facilitate the capitalization of failed banks.90 By August 1995, 11 provincial banks had received Arg$225 million from the Trust Fund for Provincial Bank Privatization in support of their privatization plans.91 By mid-September 1995, Arg$255 million had been disbursed by the Bank Capitalization Trust Fund in support of the private bank-restructuring programs.

With a view to reducing the burden imposed on banks by unremunerated reserve requirements, while safeguarding their liquidity and limiting the need for central bank support, liquidity requirements replaced reserve requirements in September 1995. The new requirements apply to all noninterbank liabilities and can be satisfied by holdings of interest-earning Bank Liquidity Certificates issued by the treasury, a special account at an international bank abroad, central bank’s reverse repurchase agreements, certain government bonds of member countries of the Organization for Economic Cooperation and Development (OECD), and certain Argentine government securities.92 Since banks can fulfill liquidity requirements with foreign assets, they can earn interest on their reserves.93 At the same time, the need for backing banks’ reserves held with the monetary authorities is reduced.

Argentina’s deposit insurance scheme was reformed in 1995 and converted to a trust fund with mandatory contributions from financial institutions, based on portfolio risk.94 Unlike the old scheme where the central bank provided part of the capital, the central bank’s charter prohibits its involvement in the new scheme.

These facilities, combined with fiscal tightening in an adjustment program supported by the IMF, proved to be effective in restoring confidence and gradually ending the banking crisis. Between May and September 1995, the banking system recovered around 40 percent of the deposit outflow. However, several banks have recovered only a modest share of the deposit loss and remain heavily dependent on the central bank’s rediscounts and the special facility administered by the Banco de la Nacion Argentina.

In September 1996, the central bank set up a US$6.1 billion pool of emergency stand-by credit from international banks. In the event of illiquidity, local banks that choose to participate in the scheme can access the funds.95

The Baltic Countries

In both Estonia and Lithuania, excess foreign reserves can be used for monetary operations and LOLR support, although only during systemic crisis. In Estonia, three major banks encountered financial difficulties causing systemwide payments delays at the end of 1992.96 The Bank of Estonia initially extended EEK 75 million of emergency credit (around 4 percent of reserve money) to the Northern Estonian Bank, one of the three problem banks that were previously the central bank’s commercial banking arm. Despite the relatively large size of the three banks, the Bank of Estonia closed them in November 1992 when the emergency credit failed to improve their positions. Although the closures had serious consequences for the economy and the financial system, they did not precipitate further bank runs. Instead, there was a shift to quality, as deposits were transferred to other banks that were perceived as being solvent, and enterprises switched to using cash in effecting transactions.

The Bank of Estonia resumed its support to the Northern Estonian Bank after it became wholly owned by the government at the beginning of 1993.97

Liquidity support and recapitalization needs were

provided through the takeover of the bank’s frozen deposit accounts in Moscow and a transfer of government bonds to the bank by the Bank of Estonia. Following an increase in the minimum capital requirement on January 1, 1996, the number of Estonian banks fell to 16 as compared with 24 in 1991.

In Lithuania, the central bank intended to maintain excess foreign exchange reserves at around 15 percent of total deposits as last-resort support capability. The reserves were used to provide liquidity support during the December 1995 financial crisis when the operations of two of the country’s largest private banks were suspended.98 With a view to easing the systemwide liquidity shortage, the central bank also temporarily suspended the penalty for reserve requirement shortfalls; nevertheless, the central bank refrained from providing support to recapitalize failing banks.

Deposit insurance was also introduced in Lithuania in 1995, in the form of the Deposit Protection Law.99 As there were no insurance funds when the banking crisis broke out at the end of 1995, that law effectively placed the government as the ultimate insurer of small individual depositors (up to Llt2,000 or US$500) of the 13 banks that were liquidated.

Hong Kong

Although four-fifths of the 179 banks registered in Hong Kong as of September 1994 were incorporated outside the colony, the authorities established LOLR facilities primarily to assist small local banks, which were heavily involved in past banking crises. Despite the fact that the banking system has in general been strong and highly profitable, banking crises occurred during 1982–86, and most recently in 1991. The first crisis was the result of aggressive lending by local banks and poor prudential supervision, particularly on risks attached to excessive property lending. The second crisis was triggered by the collapse of BCCI Hong Kong, which led to runs on some local banks.

Traditionally, the Hongkong and Shanghai Banking Corporation (HSBC), as management bank of the Clearing House, was the primary source of last-resort support to illiquid banks. However, owing to the large liquidity shortages attending the first banking crisis, the government took the lead in providing last-resort support and taking over failed banks.100

As the role of the HSBC as lender of last resort became restricted after the new accounting arrangement between the Exchange Fund and the HSBC was introduced in 1988, the Exchange Fund provided last-resort support during the second crisis.101

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