DP17862 Towards an enhanced lender of last resort and market maker of last resort
The Great Financial Crisis of 2007-2009, the European sovereign debt crisis and the financial turmoil associated with the Covid-19 pandemic help make a compelling case for two significant changes in the central banks’ design and implementation of their financial stability role. First, enhance the scale and scope of the existing lender of last resort (LOLR) mechanism by (1) extending the range of eligible counterparties and (2) extending the range of eligible instruments at the discount facility/ies. Second, create a proper market maker of last resort (MMLR) to engage in outright purchases of a range of financial instruments with a wide (in principle unrestricted provided delivery is assured) range of counterparties.
Section 2 describes the market failures – culminating in funding liquidity crises and market liquidity crises – that create the need for an enhanced LOLR and an MMLR.
Section 3 looks at the quite impressive amount of enhanced LOLR and MMLR experimentation engaged in since late 2007 by the Federal Reserve, the European Central Bank and the Bank of England.
Section 4 discusses the principal issues in the design of an effective enhanced LOLR and MMLR. A key design issue involves ensuring that their creation does not cause new market failures, especially moral hazard-driven excessive risk-taking by counterparties and issuers of securities. To minimize moral hazard, both the enhanced LOLR and the MMLR should operate on penalty terms.
