Be the "Lender of last resorts" in crisis period is a classical advise given by the Walter Bagehot to central banks. Walter mentioned, in 1873, that in time of crisis central banks must lend freely but at high rate.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.
But in sub prime crisis Fed had to be not only the lender of last resort but also "Dealer of last resort" and later it acted as private capital market.
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.
Fed responded to crisis initially with selling off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort.
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities.
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.
Fed responded to crisis initially with selling off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort.
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities.
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