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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

A central bank acts as lender of last resort during a loss of confidence in a solvent commercial bank that is facing heavy withdrawals. Which statement best captures both the benefit and the main risk of this role?

Lender of last resort support limits contagion by providing liquidity to a solvent bank facing a run, protecting the wider system. Its main cost is moral hazard, because banks expecting rescue may hold less liquidity and take more risk than they otherwise would.

  1. AIt prevents contagion across the financial system, but it may encourage banks to take excessive risk because they expect rescue (moral hazard)Correct
  2. BIt raises the bank's capital requirement permanently, but it reduces the central bank's control over interest rates
  3. CIt guarantees all depositors' returns, but it removes the need for banks to hold any liquid assets
  4. DIt lowers inflation by contracting the money supply, but it increases the number of bank runs
  5. It transfers losses to shareholders automatically, but it reduces the supply of credit to firms

Explanation

Emergency liquidity support stops a run on one bank spreading to others through confidence effects. The risk is moral hazard, since banks may expect support and take on more risk. The other options misstate the effects of the role: it does not remove liquidity needs, contract money supply or automatically impose losses on shareholders.

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