Fed Governor Mishkin has recently given a speech on this subject at Chicago Fed.
The basic idea behind lender of last resort (LORL) is that when suddenly financial markets freeze due to some event and it becomes a systemic problem, the government/central bank should intervene and provide liquidity, hence called the LORL. This is also one of the very important functions of a central bank.
To be clear, by lender of last resort, I mean short-term lending on good collateral to sound institutions, when financial markets temporarily seize up. I do not mean rescuing financial market participants from the consequences of their bad decisions by lending to unsound institutions with little capital, thereby postponing the recognition of insolvency.
Mishkin says in mature economies central banks have to provide liquidity in domestic currency but in emerging markets it makes more sense to provide liquidity in foreign currency.
First, emerging-market economies often have much of their debt denominated in foreign currency. Second, the credibility of central banks in these countries to keep inflation under control is low. Accordingly, an injection of liquidity in the form of domestic currency can actually make the financial crisis worse by raising inflation fears and thus causing the domestic currency to depreciate.
Given a debt structure characterized by liabilities denominated in foreign currency, this depreciation causes the domestic-currency value of the liabilities to rise, induces a deterioration of balance sheets, and thus causes a severe economic contraction. Moreover, a run on the domestic currency will likely be associated with a spike in nominal domestic-currency interest rates–just the opposite of what the injection of liquidity was intended to achieve–which will further damage economic prospects.
What if the Central Bank does not have adequate foreign currency reserve?
But, if a domestic central bank lacks the foreign reserves to conduct emergency liquidity assistance in foreign currency to stop a financial crisis or promote a recovery when one occurs, can another institution come to the rescue? The answer is yes, and it is often best if the assistance comes not from within the country, but from without. Liquidity provided by foreign sources can help emerging-market countries cope with financial crises without many of the undesirable consequences that can result from the provision of domestic-currency liquidity by the domestic central bank.
How should LORL function?
- Restore Confidence in the Financial System by Quickly Providing Liquidity
- Limit Moral Hazard by Encouraging Adequate Prudential Supervision
- Act as a Lender of Last Resort Infrequently