Fundamentals of Bank Supervision and the Lender of Last Resort in the Post-2008 Era: A Critical Appraisal and Forward Looking Recommendations

The generalised pumping of central bank liquidity to the western financial systems in the post-2008 period has generated serious debate and controversy. For instance, should the central bank offer liquidity assistance to solvent financial undertakings facing serious liquidity difficulties even when such institutions are not factional reserve (deposit-taking) banks? On the other hand, bank regulation and supervision have undergone extensive changes since 2008 in terms of regulatory architecture, supervisory priorities, and style of supervision. The new paramount objective of bank supervision is the preservation of financial stability. At the same time, most contemporary micro- and macroprudential supervisors tend to be central banks, the very institution that provides Lender of Last Resort (LoLR) liquidity assistance. This development has altered the breadth and content of the central banking contract with governments and society and, arguably, supports a more relaxed approach to LoLR liquidity assistance. The changed nature of supervisory objectives and central bank responsibility for systemic stability mitigates in favour of granting access to LoLR liquidity (under tightly defined conditions) to a wider range of regulated financial institutions and providers of financial infrastructure services that face insurmountable liquidity shocks in order to avert firesales (of performing assets). This should especially be the case if failure of such institutions to refinance their short-term debt would severely affect the stability of the financial system. Finally, restricting LoLR liquidity to entities within the regulatory net is fair and sound policy.