ESSAY: evaluate whether a central bank should ever allow a retail bank to fail (lender of last resort)

Question 1

Definition of lender of last resort, central bank and retail bank

Answer 1

Lender of last resort- one of the 4 roles of the central bank, means they offer liquidity support for retail banks that are at risk of insolvency because of unexpected fluctuations in cash flow

• retail bank- banks that deal with consumers on the high street
• central bank- the central bank oversees the financial system in a particular country

Question 2

Why it shouldnt allow a retail bank to fail?

Answer 2

• the failure of a retail bank can have direct adverse effects on the economy, due to a loss of savings for consumers who in turn lose confidence in the banking system and turn to other alternatives for saving
• discount and credit operations allow for short term loans to banks to meet short term needs stemming from season fluctuations in cash demand
• the retail banks are tied into the whole of the financial sector in an economy, and so the failure of one bank has knock on effects on other retail banks
• inter-bank lending can therefore be effected if one bank fails and is unable to Pay their loans back to other banks
• failure of retail banks has adverse effects on investment and growth etc
• the collapse of Lehman brothers in 07 sparked the 08/09 crisis

Question 3

Why it could allow a retail bank to fail?

Answer 3

• a small housing society or something of similar size will have less serious implications on the rest of the financial system if it was to fail, so maybe the central bank wont step in to help It because they aren’t too worried about the effect on the rest of the economy
• some banks fail because they made lots of bad and risky loans/ unsecured loans in which they are unable to reclaim, or their assets are massively illiquid or long term so can not gain the sufficient cash flow quick enough
• the new regulation of banks means that banks are less likely to fail because they know there were regulations in place to reduce their risk taking nature; allowing a small bank to fail might set an example to other banks about th serious nature of taking too big a risk

Question 4

What It depends on?

Answer 4

• it is often hard to judge whether a bank is at risk of insolvency due to being illiquid or because they have taken too many bad risks and aren’t getting the return expected from their investments; central banks may male subjective decisions that prove to be wrong
• ultimately depends on the size of the bank; too big to fail may prevail no matter how irresponsible the bank might be