Sydney - Tuesday - April 15: (RWE Aust Business News) - Australians have been observing the major financial events of the past year mainly from the sidelines, Reserve Bank governor Glenn Stevens said today. In the annual Sir Leslie Melville lecture delivered to the Australian National University in Canberra Mr Stevens said a good deal had been learned about the nature of liquidity, markets and the role of central banks over the past year. "One key lesson is the importance of liquidity in markets and to institutions, something that perhaps had not been emphasised as much as it should have been in regulation, where the emphasis has been very much on capital," he said. "We have further learned that, under conditions of great uncertainty, liquidity pressures can erupt in markets that had seldom been affected in the past. Central banks have responded quickly and flexibly to such events, but it has proven difficult to contain the pressures fully. Some quite important questions remain for the longer run, which central banks will be considering. "A second lesson is the difficulty in resolving a problem with an individual institution under strained overall conditions. Bagehot's formula provides only the most general of guidance: making it operational requires considerable judgement. If and when such an event comes, it tends to have its own unique elements and a particular set of circumstances as backdrop. Speed and flexibility in response are essential. So is consistent and early communication, since disclosure of support, if not managed very carefully, could turn out to make the situation worse rather than better. "A third lesson is that a loan of last resort is, in the end, probably simply bridging finance while a takeover or major re-structure of the recipient institution is organised. The recipient would very likely see a change in its business model, management, board and ownership structure. It could well require a pretty clear statement of temporary government support. All of this would need to be organised very quickly. "To be in a position to help, central banks have to keep an ear closely tuned to market developments - a sceptical one in the years of good times, and a sensitive one in periods of duress. A very good working relationship with the prudential supervisor, where that is not the central bank, is also essential." Mr Stevens said the concept of a lender of last resort, where the central bank lends to one specific entity when no-one else will, has been developed to deal with a panic that could easily overwhelm a perfectly sound institution that, though prudently managed, cannot possibly hold enough liquid assets to withstand the pressure unaided. "The notion has quite a history. The earliest use of the term seems to have been attributed to Sir Francis Baring, who in 1797 referred to the Bank of England as 'the dernier resort', able to provide funds to an entity when all other sources had been closed off," he said. "Early writings on the idea came from Henry Thornton (1802) and Walter Bagehot (1873). Thornton, writing in the late 18th and early 19th centuries, saw the Old Lady of Threadneedle Street as playing a stabilising role in times of crisis, to prevent a rapid reduction in credit caused by a shrinkage of the deposit base of the banking system. "Bagehot's classic Lombard Street appeared in 1873 with what has ever since been seen as the consummate statement of the responsibility of the lender of last resort. "For Bagehot, it was clear that the Bank of England should lend substantial liquid resources on a secured basis to a financial institution that had reasonable asset quality (ie was solvent) but which faced short-term funding difficulties. "Bagehot's dictum was 'Lend freely against good collateral at a high rate of interest'. It is frequently quoted still, and has been referenced more often over the past year than for a long time." Mr Stevens said the question remained about how to put it into practice. "The collateral involved is not necessarily going to be the standard sort of liquid assets. By definition, much of that collateral may already have been used before the bank reached the point of needing a loan of last resort. So the assets in question are likely to be some part of the bank's loan book, or some physical asset of the bank," he said. And he said that, since the intention is to keep the bank operating, the penalty should not be so big that it leaves the bank's interest spread between assets and liabilities negative, since that would actually hasten insolvency. "In almost all circumstances, disclosure is highly desirable: an informed market is a fair and efficient one," Mr Stevens added. "But the communications surrounding emergency liquidity assistance are critical in determining the chances of success. It would appear that it was information that the Bank of England was about to offer assistance to Northern Rock - which, objectively, should have strengthened its position compared with the alternative - that precipitated the queues in the streets. "Wholesale lenders to that institution would have already known that it was under pressure, but the news of official assistance told retail depositors, in effect, there was a problem and they reacted accordingly. "The design of the UK deposit insurance system may also have been a contributor, in that less than full insurance and the possibility of a delay in receiving insured funds can add to the incentive for a run. "In this complex situation, the UK authorities found it difficult to stabilise things, until the government issued a strong guarantee of Northern Rock's obligations. "A final issue is the re-financing of the last resort loan in the private sector once the situation has stabilised. If there is ongoing general market turmoil, as in the case in question, then it can be difficult for a private firm to replace the public funding at a price that allows the bank in question to remain viable. "In such an instance, the government faces the choice between providing the institution with longer-term support - either a long-term loan or taking ownership - subsidising a takeover or closing it. "In the UK case, Northern Rock is being taken into public ownership for a time. "In the US, the takeover of Bear Stearns - which, of course, is not strictly a bank - by JPMorgan Chase is being assisted by a long-term facility provided by the Federal Reserve, which carries some credit risk for the Fed. In each case, there is ongoing discussion about what value the previous shareholders can reasonably expect to get from the resolution. The prospect of legal action is, of course, a potential further complication. "All this illustrates that the role of lender of last resort is actually quite challenging in the modern world. Thankfully, observations in the time series of large financial near failures are few, and recent ones have been in other countries. But when they do occur, it is important to learn as much as we can from them. Central banks and supervisory authorities around the world are seeking to do just that."
