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---

### I. Introduction
- Central banks (CBs) provide reserve money and other forms of liquidity through:
  - Open market operations (OMOs) when the market has an ex ante shortage of reserve money.
  - Payment system facilitation (e.g., intra-day loans or a credit standing facility (SF)).
- Focus of the paper: bilateral/idiosyncratic lender of last resort (LOLR) support — discretionary CB liquidity to one or a few institutions to avoid spillovers to financial stability.
- Scope highlights:
  - Distinction between idiosyncratic and systemic support and terminology.
  - Institutional eligibility and considerations before LOLR to non-banks.
  - Approaches to managing fire-sale risk.
  - Operational challenges: length of support, FX needs, identification of “good” collateral, and forward-looking operational issues.
- Topics left for later work: recovery, fiscal support role, living wills, detailed resolution mechanisms; moral hazard and appropriate lending rate only touched on here.

### II. Central Bank Liquidity Provision — Stressed Times
- Types of shocks and CB responses:
  - Idiosyncratic shock: one or a few banks face abnormal liquidity pressures; CB response is discretionary and should trigger heightened regulatory oversight.
  - Systemic shock: market-wide increase in demand for reserve money; CB is the sole provider in a closed reserves system.
- Nature of demand may be for:
  - Reserve money (possibly at longer term maturity).
  - Foreign exchange (FX).
  - Liquid securities (e.g., treasury securities usable as collateral).
  - Term funding rather than immediate liquid assets.
- Operational distinctions:
  - OMOs: initiative of the CB.
  - Standing facilities (SF): automatic, at the initiative of individual banks, typically overnight and non-discretionary.
- Key operational point: idiosyncratic shocks may not require additional aggregate reserve money; credit risk concerns or market fragmentation can leave an individual bank short of liquidity.
- Example: Northern Rock (U.K., September 2007) — LOLR provision had to be offset by a reduction in normal OMO lending to avoid excess aggregate reserve money.
- Paper definitions:
  - “Idiosyncratic”: lending to one or a small group of banks outside normal monetary policy operations.
  - “Systemic”: generally available operations extending normal monetary operations when the market as a whole is stressed.

### III. Bilateral Lender of Last Resort (LOLR)
- Purpose and characteristics:
  - Needed when an individual financial institution or a few cannot maintain or roll over funding.
  - Discretionary, bilateral, provided at a penalty rate.
  - Should trigger enhanced regulatory oversight and conditionality.
  - CBs should require funding plans showing a viable path back to a normal funding mix without continued LOLR reliance.
- Moral hazard and mitigation:
  - Discretion reduces moral hazard by creating uncertainty about CB support.
  - Mitigation tools: uncertainty about support, punitive penalties on management/shareholders, strict frameworks for enhanced regulatory oversight and prompt corrective action.
  - Example: Dodd-Frank Act (2010) restricts Fed’s ability to provide idiosyncratic support to reduce automatic bail-out perceptions.
- Supervisory intrusion and conditionality:
  - Recipients must face enhanced supervision; LOLR should not be used solely to comply with regulatory ratios.
  - Funding plans required; persistent governance failures (e.g., fraudulent connected-party lending) should preclude CB support until addressed.
- Operational point: committed liquidity facilities count toward regulatory liquidity but differ from discretionary idiosyncratic LOLR (see Box 2).

### IV. Systemic Lender of Last Resort at the Central Bank’s Initiative
- Characteristics:
  - CB provides reserves on a multilateral basis (auction-type mechanisms) when the banking system faces increased demand for reserves.
  - Systemic emergency response is an adjunct to liquidity management via OMOs; may not imply a change in policy stance.
- Operational adjustments:
  - Change OMO terms: lengthen tenure, expand eligible collateral, create new targeted facilities.
  - Expand counterparty lists to direct liquidity where needed, contingent on counterparties’ willingness/ability to on-lend.
- Crisis-era evidence:
  - Term Auction Facility (TAF) (U.S.) expanded OMO counterparties beyond Primary Dealers but had limits due to credit risk in on-lending to non-banks.
  - Eurosystem full-allotment LTROs faced collateral limitations and fragmentation, limiting effectiveness.
- Alternative government systemic tools:
  - Asset swaps: provide liquid government securities against less liquid assets for a fee (example: Norway).

### V. Committed Liquidity Facilities — Where Do They Fit? (Box 2)
- Purpose and timeline:
  - Announced beginning in late 2011 to assist banks in meeting the Liquidity Coverage Requirements (LCR) under Basel III (expected full implementation by January 1, 2019).
  - Examples: Reserve Bank of Australia (November 2011); South African Reserve Bank (May 2012).
- Key features:
  - CB commitment to provide liquidity to eligible institutions against collateral not eligible for OMOs.
  - Recognized by Basel III as a means to access a specified amount of liquidity using repurchase agreements.
- Design to limit reliance and moral hazard:
  - Commitment fee to reduce routine use.
  - Entry request is at CB discretion; once fee paid the CB commits to provide liquidity against defined collateral (functionally akin to an automatic facility).
  - Eligibility criteria limit access if collateral exhausted.
- How CLFs differ from idiosyncratic operations:
  - Response to systemic shortage of high quality assets (e.g., limited government debt issuance).
  - Systemic-response instrument, charges a commitment fee, and functionally commits CB to liquidity provision once conditions met.
  - Exhaustion of CLF-eligible collateral is where LOLR becomes relevant.
- Contextual crisis instances and figures:
  - Norway: October 2008 operation with a NOK 350 billion market support facility exchanging covered bonds for treasury bills.
  - U.S. GFC measures:
    - FDIC Temporary Liquidity Guarantee Program and TARP with authority to purchase or guarantee $700 billion (later reduced to $475 billion).
- Institutional eligibility:
  - Bilateral LOLR often limited to banks because of demand deposit roles and payment system functions.
  - Legal authority to lend to non-banks is useful as contingency; moral hazard from mere legal authority mitigated by clear policy statements.

### VI. Nonbank Financial Institutions (NBFIs) and FMIs (Box 2 & Box 3)
- Distinctions:
  - Principal intermediaries: CCPs, securities dealers (SDs).
  - Agent intermediaries: mutual funds (MFs), money market mutual funds (MMMFs), asset managers.
- Principal intermediaries:
  - FMIs concentrate systemic risk; illiquidity in CCPs can spill over.
  - Access to CB support: some CCPs have banking licenses; U.S. Dodd-Frank permits Fed credit to CCPs in unusual and exigent circumstances; U.K. BoE extended liquidity support to non-bank CCPs.
  - Large SDs: idiosyncratic support should be rare and limited to OMO counterparties or systemically important SDs.
  - Asset-swap alternative: provide liquid government securities for non-government paper without expanding reserve money.
- Agent intermediaries:
  - Runs on MFs/MMMFs during GFC led to authorities supporting investor-creditors and borrowers.
  - CBs unlikely to lend directly to large numbers of nonbank borrowers due to informational constraints; indirect support used (e.g., TARP, Funding for Lending).
  - Pre-emptive regulatory measures are often more effective than LOLR for cash-like products.
- Policy for non-bank support:
  - If provided, design support to address specific systemic problems; not easier terms than banks.
  - Conditional on enhanced supervision and MOUs for information sharing and enforceability.
  - Regulatory measures: clarify that certain investments are not cash equivalents; require clearer disclosures; consider minimum investment amounts; plan gates and fees to manage runs.

### VII. Growing Importance of LOLR for CCPs (Box 3)
- Policy context:
  - G20 2009 requirement to centrally clear standardized OTC derivatives increased CCP volumes and the importance of liquidity backstops.
  - FSB safeguard: “appropriate liquidity arrangements for CCPs in the currencies they clear.”
  - BIS Economic Consultative Committee: work towards no technical obstacles for timely bilateral LOLR to solvent and viable CCPs without pre-commitment.
- Central bank arrangements:
  - Some CCPs with banking licenses (Eurex Clearing, LCH. Clearnet SA) have normal CB liquidity access.
  - Bank of England extended Sterling Monetary Framework in November 2014 to broker dealers and CCPs.
  - Other CBs able to provide LOLR to CCPs: Sveriges Riksbank, Swiss National Bank.
- Solvency and viability framing:
  - Traditional LOLR applies to solvent but illiquid entities; read across to CCPs is possible but assessment is challenging in crisis times.
  - Assessment challenges: mark-to-market volatility; valuation of non-tradable assets; supervisory biases to avoid reputational risk.
- Dynamic assessments:
  - Move toward forward-looking viability requirements (example: Bank of Canada 2015 consultation paper).
  - Distinguish “point in time” vs “forward looking” solvency assessments.
- Operational implications:
  - Short-term bilateral LOLR to CCPs may require state support comfort, ex ante agreements on restructuring, strict timelines, and conditionality.

### VIII. LOLR and Resolution (Box 4)
- Theoretical vs practical resolution:
  - Immediate resolution may be theoretically preferred but legal and institutional frameworks often incomplete; resolving an insolvent bank may trigger instability.
- Conditions and safeguards for bilateral LOLR to potentially insolvent entities:
  - Restrict corporate operations to core activities while ascertaining recapitalization prospects.
  - Do not support absent realistic time-bound recapitalization or resolution plans.
  - Insolvent banks and banks below minimum regulatory capital should not be eligible for monetary policy operations; manage prohibition carefully to avoid provoking deposit runs.
  - Bilateral LOLR to possibly insolvent entities should be fully indemnified by the government to protect the CB balance sheet.
  - Limited extension of LOLR to systemic entities may be reasonable where solvency concerns will be resolved with certainty and within a short time frame; indemnity from government recommended.
- “Systemic-ness” considerations:
  - Support may be justified for systemically important institutions (SIBs/SIFIs), but confining LOLR to SIBs raises “Too Big to Fail” moral hazard and equal-treatment issues.
  - Recommended framework for assessing systemic importance includes: Size; Complexity; Services provided; Interconnectedness; Risk of contagion.
  - CBs should adopt arrangements for quick systemic assessments.
- Tackling fire sales:
  - Drivers: need for cash (e.g., margin calls) and desire to limit exposure to price falls.
  - Non-recourse lending with a suitable haircut can address credit-risk aspect of fire sales; exposes CB to credit risk—government indemnity recommended.
  - Example combined pricing approach (illustrative structure in source):
    - (i) Recourse lending at the policy rate plus 100 basis points (bps) and an X percent haircut.
    - (ii) Non-recourse lending at the policy rate plus 150 bp, a fee of 25 bp and a haircut of 2X percent.
  - Non-recourse lending analogous to selling a put option; alternative is government/CB purchase of out-of-the-money puts.
  - Operational channeling: operate via existing CB counterparties to avoid creating many new counterparties.
- Key operational challenges for LOLR:
  - Duration: some CBs address idiosyncratic needs for as short as a week; others set limits between one month and three months. The GFC showed liquidity problems may persist for several months or years; time-limited provision desirable with funding plans and review points.
  - Cost/pricing:
    - ECB: fixed spread over overnight lending facility.
    - HKMA: policy rate plus a spread reflecting market conditions.
    - Bank of Canada: charged its bank rate.
    - BOE: recommends variable rates and high fees to discourage use but avoid accentuating strains.
    - “Reduction approach”: high initial rate for short-term, lower penalty rate for longer-term needs.
    - In systemic lending, the lending rate cannot be penal since it determines short-term rates.
  - Collateral adequacy:
    - In idiosyncratic responses, institutions may have exhausted high-quality assets; CB may accept unencumbered assets if: (i) ownership transferable; (ii) asset can be priced; (iii) CB can manage asset and associated risks.
    - Bagehot’s principle (lend against “good” collateral) may not be fully feasible in bilateral LOLR, but collateral should always be adequate to cover anticipated losses.

### IX. Collateral and Risk Control Measures (Appendix III)
- Legal and due diligence:
  - Ensure legal title to collateral; thorough due diligence and ex post verification checks required.
  - Handling and administrative costs matter; loan books may be operationally cumbersome and legally restricted in some jurisdictions.
  - Pre-positioning collateral (amending loan documentation) can facilitate mobilization.
- Indemnities:
  - CBs should consider government indemnities where counterparty quality, collateral, size/length of support, or exit strategy raise concerns.
  - Indemnity obligations should be unconditional, irrevocable, and callable on demand; procedures with the Treasury should be agreed.
  - Alternatives: government recapitalization of CB if capital falls below a threshold; recapitalization should be by marketable securities costing market rates and ranking pari passu.
  - Note: provision of indemnities can be credit negative for sovereigns and raise contingent liability scrutiny by credit rating agencies.
- Supervisory responses — domestic institutions:
  - Enhanced oversight, early intervention, prompt corrective actions.
  - Funding plans: project assets/liabilities at least one year out; include stress assumptions; updated regularly.
  - Daily or intra-daily liquidity updates; binding remedial measures (asset sales, bar on dividends/bonuses, management changes).
  - Use of provided liquidity limited to core business; not for capital management exercises like debt buybacks.
- Supervisory responses — cross-border banks:
  - Complexities from branches vs subsidiaries; risks include up-streaming of funds and parent withdrawal of support.
  - Mitigants: evidence from parent of lack of alternative funding, MOUs for information sharing, demonstration that local operation is systemically important.
  - Possible ring-fencing of local assets/liabilities to prevent relocation to parent.
- FX LOLR guidance:
  - FX LOLR may be needed where the system is “partly-dollarized” or reliant on cross-border FX funding.
  - FX supplies are finite; FX LOLR during the GFC was largely systemic rather than bilateral.
  - Some 14 CBs borrowed USD via Fed swap lines; some European CBs engaged in swaps and repos with the ECB.
  - IMF considers potential FX LOLR needs when estimating official FX reserve levels.
  - For fully “dollarized” countries, options include earmarked government funds or dedicated contingency funds financed by banks.
  - Policy measures: tighten FX prudential liquidity requirements; macroprudential limits on FX loans or levies on FX deposits.
  - Preparatory steps: quantify scale and currency denomination of likely FX need (assume e.g., a non rollover of X percent of short-term FX liabilities), match against FX resources, investigate currency swap lines, consider quantitative restrictions or administrative controls (ring-fencing, deposit conversion) as last resorts.

### X. Collateral Acceptance Criteria and Operational Practices (Appendix III details)
- Collateral acceptance attributes to consider:
  - Legal certainty, central bank status, credit assessment, ease of transferability, ease of valuation, ease of handling, effectiveness for emergency support, data availability, absence of “close links,” diversification.
- Examples of potential collateral types and issues:
  - Corporate or bank securities — “close links” and valuation in illiquid markets.
  - Securitized assets — transparency of underlying pool and paydown dependence.
  - Residential loans — operational and legal mobilization challenges.
  - Commercial mortgages — bespoke agreements pose legal/operational issues.
  - Equities — valuation volatility and shareholder implications; avoid “close link” exposures.
- Loan collateral eligibility variables:
  - Type of loan, loan performance (loan-to-value), credit quality, borrower consent for transfer, arrears threshold, debtor income verification, defined loan-to-value threshold, eligible loan types (e.g., annuity loans only).
- Risk tolerance and haircut methodology:
  - Two-step approach:
    - Phase One: adopt another CB’s conservative haircuts with an add-on for local specifics (e.g., mirror ECB schedules + add-on).
    - Phase Two: develop advanced quantitative haircuts (value-at-risk) requiring market data.
  - Valuation approaches (preferred to less preferred):
    - Step 1: daily market price from providers (stale not more than five days rule of thumb).
    - Step 2: theoretical valuation using discounted future cash flows (high sophistication).
    - Step 3: implied prices using proxies/bootstrapping (moderate sophistication).
    - Step 4: face value less estimated upcoming interest payments and larger haircut (low sophistication).
- Limits and due diligence:
  - Introduce borrowing/collateral limits; internal limits preferred.
  - Haircut add-ons and valuation markdowns for non-standard features or double-default risks.
  - Ex ante verification checks where possible; ex post checks necessary when urgent requests arise.

### XI. Minimizing Stigma — The Case of Open Market Operations (Appendix IV)
- Rationale:
  - Using OMOs to provide liquidity when several banks are stressed can reduce stigma associated with bilateral LOLR.
  - Possible design: expand collateral accepted in the monetary policy framework and provide (possibly longer term) OMOs using an interest rate higher than the policy target.
  - Public announcement of such operations can aid market confidence.
- Operational design:
  - Provide OMOs against collateral normally reserved for standing facilities; offer liquid securities instead of reserves where appropriate.
  - Example precedent: U.S. Federal Reserve’s TAF — longer term liquidity to a wider set of counterparties against a wider list of collateral.
- Experience:
  - Reserve Bank of New Zealand, Reserve Bank of Australia, and to some extent the ECB adopted similar approaches during the GFC.
  - In the euro zone, collateral constraints persisted for peripheral banks despite ECB collateral expansion; LTRO reserves did not flow as intended.
- Risks and stigma dynamics:
  - Removing stigma from OMO-provided liquidity increases risk of stigma for bilateral LOLR.
  - Strong banks may publicly distance themselves from such operations, creating signaling problems.
  - Moral suasion can be used to manage perceptions (example: BOE engagement with larger U.K. banks).
- Design principles:
  - CBs should have clear principles for providing such liquidity and avoid ad hoc changes.
  - Announce eligibility criteria and goals for systemic OMOs; manage disclosure with time lags; clarify that increased supervisory intrusion and conditionality do not apply to market-wide OMOs.

### XII. Stakeholder Coordination, Decision-making, and Operational Procedures (Appendix IV)
- Roles and responsibilities:
  - CBs operationally best suited to provide LOLR where CB money is required.
  - Ex ante rules and procedures among CB, treasury, supervisors enable swift action and limit political pressure.
  - Regular testing of LOLR processes and internal working groups recommended.
- Supervisor responsibilities:
  - Ex ante monitoring of funding flows and collateral holdings.
  - Determination of solvency and viability, formulation of funding plans, ex post compliance monitoring.
  - Cross-border cooperation as needed.
- Decision-making and indemnities:
  - Sovereign may retain decision-making and indemnify CB (Triparty MOU example: BOE, PRA, chancellor/treasury).
  - CB lending as the Treasury’s agent requires clear indemnity and legal constraints.
- Disclosure and stigma:
  - Ex post disclosure needed for accountability; timing should avoid provoking runs.
  - U.K. experience: disclosure of Northern Rock support precipitated a deposit run.
  - U.S. Dodd-Frank disclosure lags: regular discount window/OMO loans disclosed ~two years after operation; 13.3 operations disclosed one year after authorization termination.
- Sterilization:
  - Whether to sterilize depends on policy objectives; asset swaps do not create reserve money and thus do not require sterilization.

### XIII. Key Outstanding Challenges, Summary and Conclusions
- Central bank autonomy:
  - CBs should not assume LOLR risks so large that realized losses would undermine public confidence.
  - CBs should retain discretion as emergency interventions involve judgment; uncertainty remains about how much a CB can lose without threatening independence.
  - If sovereign unwilling/unable to indemnify LOLR, CB may face long-run stability risks by assuming such burdens.
- Competition policy:
  - Idiosyncratic support uses public funds and can create competitive distortions.
  - European Commission approach: LOLR at CB initiative, at a suitably high rate to illiquid but fundamentally solvent entities, is not state aid; CB lending to potentially insolvent entities or under-collateralized lending indemnified by state is considered state aid.
  - Recommendation: competition frameworks should not unduly restrict CB flexibility; exemptions/accelerated procedures advisable where financial stability threatened.
- Public banks:
  - Public banks can be eligible for LOLR; support should be no cheaper than that for private banks.
  - Benefits to government from CB support often pass back to government with delay per profit redistribution.
- Key propositions and findings (verbatim preserved):
  - There are instances where the provision of LOLR funds to some non-banks is warranted, but careful consideration needs to be given to the reasons for doing so and the way in which the support is structured. Idiosyncratic LOLR for NBFIs is unlikely to be appropriate, except in the case of systemically-important CCPs. As a contingency, CBs may benefit from having statutory powers in place to lend to regulated and supervised NBFIs in exceptional circumstances. If the exceptional liquidity demand of non-banks has arisen as a result of market inefficiencies or regulatory loopholes, policies should be put in place to limit or prevent these arising again in the future.
  - System-wide problems in NBFIs may also justify a system-wide response to prevent asset fire-sales, which may have damaging consequences for financial stability. Tackling asset fire-sales is a difficult task and will most likely involve the CB (or government) accepting additional risk. Non-recourse lending (or, possibly, the sale of out-of-the-money put options) may offer an effective tool to address these problems without creating excessive moral hazard. But this is not market making, in the sense of making a two-way price and expecting to trade in both directions: the authorities are more likely to become “buyer of last resort” and—if so—should be clear that this is the case.
  - Solvency requirements remain a key component of LOLR when applied on a forward looking basis, and should complement the viability assessment of the institution. There is a strong argument to be made for lending to all regulated banks which are judged not to be insolvent, are able to provide collateral and—importantly—are seen as viable. But a business which is not viable should be wound down, even if it is solvent today.
  - While LOLR support is intended to be temporary, the use of published time bound maturity limits can “tie the hands” of a CB in an unhelpful way. It proposes that the maturity of LOLR support only be as long as the underlying liquidity need, while the counterparty should at all times demonstrate a credible prospect of repaying the operation on or before maturity.
  - An appropriate balance has to be found in terms of pricing, both the interest rate and any fees: the cost should be high enough to encourage banks to seek other forms of funding—including obtaining additional capital—but not so high as to exacerbate liquidity strains and make survival of the institution (and repayment of LOLR) less likely.
  - Regulatory intervention and conditionality may be seen as an important element of the costs imposed on LOLR beneficiaries. Effective regulatory intervention and conditionality may be difficult in the case of NBFIs, and also foreign branches or subsidiaries of foreign banks.
  - The ability to provide FX liquidity is an important safety net in many markets. For the majority of CBs, their ability to meet FX liquidity needs will be constrained and this should be clearly communicated to the market. Prudential or macroprudential measures may have a role in reducing potential FX calls, but are unlikely to eliminate them entirely.

*Source: _wp1610 — extracted content from the referenced IMF Working Paper PDF (_wp1610) provided above.*

### 1. Central Bank Response to Liquidity Problems ....................................................................10

### 1. Central Bank Response to Liquidity Problems

### I. Introduction
- Central banks (CBs) provide reserve money and other forms of liquidity through:
  - Open market operations (OMOs) as part of monetary policy implementation when the market has an ex ante shortage of reserve money.
  - Payment system facilitation (e.g., intra-day loans or a credit standing facility (SF)).
- This Working Paper focuses on bilateral/idiosyncratic lender of last resort (LOLR) support: discretionary CB liquidity to one or a few institutions to avoid spillovers to financial stability.
- The Global Financial Crisis (GFC) of 2008–09 revived interest in LOLR design and operational modalities.
  - Traditional view (Walter Bagehot, 1873): lend freely and at a high interest rate against good collateral.
  - In practice during the GFC, CBs used a variety of approaches, including some beyond their normal frameworks.
- Paper scope:
  - Distinction between idiosyncratic and systemic support and terminology (Section II).
  - Institutional eligibility and considerations before LOLR to non-banks (Sections III and IV).
  - Approaches to managing fire-sale risk when individual institutions face asset-market shocks (Section V).
  - Operational challenges: length of support, FX needs, identification of “good” collateral, and forward-looking operational issues (Sections VI and VII).
- Topics left for later work: recovery, fiscal support role, living wills, and detailed resolution mechanisms; moral hazard, appropriate lending rate, and some resolution issues are only touched on here.

### II. Central Bank Liquidity Provision — Stressed Times
- Types of shocks and CB responses:
  - Idiosyncratic shock: one or a few banks face abnormal liquidity pressures; CB response is discretionary and should trigger heightened regulatory oversight.
  - Systemic shock: market-wide increase in demand for reserve money; CB is the sole provider in a closed reserves system.
- Nature of the demand may be for:
  - Reserve money (possibly at longer term maturity).
  - Foreign exchange (FX).
  - Liquid securities (e.g., treasury securities usable as collateral).
  - Term funding rather than immediate liquid assets.
- Distinctions in operations:
  - OMOs: initiative of the CB.
  - Standing facilities (SF): automatic, at the initiative of individual banks, typically overnight and non-discretionary.
- Key operational point: in an idiosyncratic shock there may be no general need for additional reserve money; credit risk concerns or market fragmentation can leave an individual bank short of liquidity.
- Examples:
  - Northern Rock (U.K., September 2007): LOLR provision had to be offset by a reduction in normal OMO lending to avoid excess aggregate reserve money.
- Paper definition:
  - “Idiosyncratic”: lending to one or a small group of banks outside normal monetary policy operations.
  - “Systemic”: generally available operations extending normal monetary operations when the market as a whole is stressed.

### Bilateral lender of last resort (LOLR)
- Purpose:
  - Needed when an individual financial institution or a few are unable to maintain or roll over funding (retail or wholesale).
  - Applies to single institutions or groups with similar business models/geography if market doubts longer-term viability.
- Characteristics of bilateral LOLR:
  - Discretionary, bilateral, provided at a penalty rate.
  - Should trigger enhanced regulatory oversight and conditionality.
  - CBs should require funding plans that show a viable path back to a normal funding mix without continued LOLR reliance.
- Moral hazard and discretionary action:
  - Discretion reduces moral hazard: uncertainty about CB support reduces incentives to take excessive liquidity risk.
  - Moral hazard defined as reducing incentives for entities to protect themselves against risky outcomes (Lavoie et al., 2011).
  - Mitigation tools: uncertainty about support, punitive penalties on management/shareholders, strict frameworks for enhanced regulatory oversight and prompt corrective action.
  - Example: Dodd-Frank Act (2010) restricts Fed’s ability to provide idiosyncratic support to reduce automatic bail-out perceptions.
- Supervisory intrusion and conditionality:
  - Institutions receiving bilateral LOLR must face enhanced supervision and conditionality to ensure repayability and appropriate use of public funding.
  - LOLR should not be used solely to comply with regulatory ratios.
  - Banks in receipt of support should provide funding plans; problems such as persistent weak governance (e.g., fraudulent loans to connected parties) should preclude CB support until addressed.
- Committed liquidity facilities vs idiosyncratic LOLR:
  - Some CBs introduced committed liquidity lines that count towards regulatory liquidity requirements; these are committed (not discretionary) and therefore different from idiosyncratic LOLR (see Box 2).

### Systemic lender of last resort at the central bank’s initiative
- Characteristics:
  - CB provides reserves on a multilateral basis (auction-type mechanisms) when the banking system faces increased demand for reserves.
  - Systemic emergency response is effectively an adjunct to liquidity management via OMOs.
  - May not imply a change in monetary policy stance but can aid an impaired monetary policy transmission mechanism.
- Operational adjustments for systemic lending:
  - Change OMO terms: lengthen tenure, expand eligible collateral, or create new facilities targeted to specific market issues (e.g., fragmentation, impaired transmission).
  - OMOs allow CB market counterparties to direct liquidity to participants most in need without distorting price mechanism—contingent on counterparties’ willingness/ability to on-lend.
- Crisis-era evidence:
  - Term Auction Facility (TAF) (U.S.): expanded Fed’s OMO counterparties beyond Primary Dealers but did not meet all needs due to credit risk concerns in on-lending to non-banks.
  - Eurosystem full-allotment LTROs faced collateral limitations and fragmentation, limiting effectiveness in satisfying liquidity needs.
  - Appendix I: overview of major CB responses to the GFC.
- Alternative systemic responses by government agencies:
  - Governments can use asset swaps to provide liquid government securities against less liquid assets for a fee, leveraging their debt issuance capacity. Norway is cited as an example of such use.

### Box 1 — Terminology (summary points)
- Common terms: “LOLR,” “Emergency Liquidity Assistance” (ELA), and “Exceptional Liquidity Assistance.”
- Usage varies:
  - Some CBs use LOLR for discretionary idiosyncratic lending; others use ELA interchangeably or reserve ELA for systemic provision.
  - “Exceptional” often denotes prolonged assistance (could be idiosyncratic or systemic).
- Standing credit facility (SF) is not a LOLR instrument: SF is typically overnight and non-discretionary.
- Variations in terminology can create confusion about whether assistance is bilateral or multilateral and about expected duration.

### Key operational and policy implications (extracted)
- CBs should maintain discretion in idiosyncratic LOLR to limit moral hazard.
- Enhanced supervision and conditionality are essential when providing bilateral LOLR.
- CBs must evaluate alternative funding solutions before extending bilateral LOLR and require funding plans demonstrating exit paths.
- Systemic responses may require changes to OMO terms, collateral frameworks, venue expansion of counterparties, or creation of new facilities.
- Coordination with fiscal authorities can offer alternative tools (repos, deposits, asset purchases, swaps, guarantees), but fiscal authorities often lack immediate access to reserve money.
- In stressed markets, market-based allocation of liquidity via OMOs may be ineffective if intermediaries cannot or will not on-lend due to credit concerns.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1610.pdf*

### Box 2. Committed Liquidity Facilities: Where Do They Fit?

### Box 2. Committed Liquidity Facilities: Where Do They Fit?

### Committed Liquidity Facilities (CLFs): purpose and design
- CLFs were announced beginning in late 2011 to assist banks in meeting the Liquidity Coverage Requirements (LCR) envisaged under Basel III, which are expected to be fully implemented by January 1, 2019.
- Examples:
  - Reserve Bank of Australia (November 2011).
  - South African Reserve Bank (May 2012).
- Key features common to the examples:
  - Commitment by the central bank (CB) to provide liquidity to certain eligible institutions against collateral not eligible for open market operations (OMOs).
  - Recognized by Basel III as a means for banks to access a specified amount of liquidity using repurchase agreements.
- Design elements intended to limit reliance and moral hazard:
  - CLFs attract a commitment fee designed to reduce reliance on the facility compared to holding high quality liquid assets in normal times.
  - A bank’s request to enter a CLF is at the CB’s discretion, but once the fee is paid the CB commits to satisfy the needs of participating banks against a defined set of collateral, making these akin to an automatic facility.
  - Eligibility criteria apply, particularly with respect to collateral accepted; if a counterparty exhausts this collateral set, it cannot access the CLF and will most likely need to mobilize lower quality assets to obtain additional liquidity.

### How CLFs differ from idiosyncratic central bank operations
- CLFs are created in response to a systemic shortage of high quality assets within the system (for example, where the government does not issue a large amount of debt securities).
- CLFs:
  - Are systemic-response instruments rather than purely idiosyncratic emergency operations.
  - Charge a commitment fee (to discourage routine use).
  - Functionally commit the CB to provide liquidity against a defined collateral set once fees and eligibility criteria are met, resembling an automatic facility.
- If a counterparty exhausts eligible collateral under a CLF, the lender will likely need to mobilize lower quality assets; such situations are where the lender-of-last-resort (LOLR) function becomes relevant.

### Context: fiscal and other support during crises (selected instances)
- Norway: operation in October 2008 when the government introduced a NOK 350 billion market support facility permitting banks to exchange covered bonds for treasury bills.
- U.S. during the GFC:
  - FDIC created the Temporary Liquidity Guarantee Program guaranteeing some senior unsecured debt securities and selected non-interest-bearing transaction accounts, for a fee.
  - Troubled Asset Relief Program (TARP) introduced in October 2008 gave the Treasury authority to purchase or guarantee $700 billion (later reduced to $475 billion) of troubled assets owned by financial institutions.
- Deposit insurance coverage was increased in a number of countries during the GFC.

### Institutional eligibility: banks versus non-banks
- “Banks are special” argument:
  - Bilateral LOLR is often limited to banks because of their role in taking demand deposits payable at par and readily transferable, enabling non-cash payments and immediate availability of funds.
  - The financial safety net for banks typically comprises deposit insurance, capital and liquidity requirements, supervision, and access to CB liquidity facilities; banks pay for the safety net (e.g., levies for deposit insurance and supervision; balance sheet costs for holding capital and liquid assets; LOLR operations typically carry a penalty cost).
- Legal authority and contingency planning:
  - Even if a CB does not expect to lend to non-banks, having legal authority to do so for contingency purposes is useful to avoid delays that could exacerbate crises.
  - Moral hazard from mere existence of legal authority can be mitigated by clear policy statements (e.g., presumption that resolution rather than rescue is the first choice).

### Nonbank financial institutions (NBFIs) and financial market infrastructures (FMIs): rationale and form of support
- Distinction between intermediaries:
  - Principal intermediaries: central clearing counterparties (CCPs), securities dealers (SDs).
  - Agent intermediaries: mutual funds (MFs), money market mutual funds (MMMFs), other asset management companies.
- Principal intermediaries:
  - FMIs concentrate systemic risk; illiquidity in FMIs, particularly CCPs, can spill over and exacerbate instability.
  - CCP protections: capital and margins should protect CCPs, but sharp market moves or timing mismatches in cash flows can create vulnerabilities.
  - Many FMIs are considered systemically important in their own jurisdiction.
  - Access to CB support:
    - For FMIs not eligible for standing CB facilities or that exhaust eligible collateral, access to LOLR may need to be considered.
    - Examples: U.S. Dodd-Frank Act permits the Fed to provide credit in unusual and exigent circumstances to CCPs; some euro area CCPs are legally structured as banks and thus have access to CB standing facility credit; U.K. BoE has explicitly extended possibility of liquidity support to non-bank CCPs.
  - Large SDs:
    - May play an important role in supporting secondary market trading and repo markets, central to monetary policy transmission and government financing.
    - Distinguish supporting: (i) the market-making function; (ii) the SD itself; (iii) short-term funders of the SD.
    - Idiosyncratic support for SDs should be rare and limited to OMO counterparties or systemically important SDs.
  - Asset-swap as an alternative:
    - Where problems are in non-government paper, CB (or government debt management agency) could provide support via an asset swap (providing liquid government securities against illiquid private sector bonds) to address needs without expanding reserve money balances.
- Agent intermediaries:
  - Runs on MFs/MMMFs during the GFC caused authorities to support both investor-creditors and borrowers to minimize disruption.
  - CBs are unlikely to lend directly to large numbers of nonbank borrowers due to informational and relationship constraints; indirect support (e.g., TARP, Funding for Lending) was used in some jurisdictions.
  - Demand for NBFI LOLR often arises from underestimation or under-provision for liquidity and credit risk, and from products marketed as “cash equivalents” despite meaningful differences from bank deposits.
  - Pre-emptive regulatory measures are often more effective than LOLR for such products.

### Policy recommendations and operational safeguards for non-bank LOLR
- Support to non-banks (if provided) should be:
  - Designed to address the specific systemic problems identified; it need not replicate bank LOLR and should not be provided on easier terms than to banks.
  - Conditional on enhanced supervision and memoranda of understanding (MOUs) with supervisors to ensure information sharing and enforceability of conditionality.
- Specific regulatory and structural measures suggested for agent-intermediary risks:
  - Institutional investors could be prohibited from treating certain investments as equivalent to cash.
  - Asset managers should be required to make clearer disclosures (including in short-form prospectuses) that there is no liquidity guarantee and that redemption rights are not matched by an obligation on anyone to buy assets sold to meet redemptions.
  - Introduce minimum investment or transaction amounts to reduce retail use of risky cash-like products.
  - Gates and fees to manage runs should be planned in advance; asset managers should have clear plans for their use (noting that the prospect of gates might itself provoke runs).
- Conditionality and moral hazard:
  - Any NBFI receiving LOLR should face enhanced supervision and conditionality to provide the CB comfort that loans can be repaid and used appropriately.
  - Conditionality may be more difficult when the ultimate beneficiaries are nonfinancial companies or large numbers of exiting investors; authorities should consider alternative instruments (such as guarantees) if broader reach is needed.

### Operational stance on widening LOLR parameters
- The paper’s general line:
  - CBs should have the ability and discretion (but not the obligation) to widen operational parameters of LOLR beyond banks and against a wider-than-normal collateral list, subject to strict conditions and only where necessary to preserve financial stability.
  - Two important issues when considering departures from conventional LOLR practice: (i) protecting the CB’s balance sheet; and (ii) minimizing moral hazard.
- Trade-offs:
  - Prohibiting all support to non-banks (“committing to inaction”) can be time-inconsistent and may need to be changed in the face of unexpected threats; appropriate balance between rules and discretion is country-specific and depends on market structure, supervisory capacity, and relative risks.
- Crisis costs cited:
  - Laeven and Valencia (2012) estimate the average loss in output resulting from 147 banking crises between 1970 and 2011 as 23 percentage points of GDP.

*Source: Box 2. Committed Liquidity Facilities: Where Do They Fit?*

### Box 3. Growing Importance of Lender of Last Resort for Central Clearing Counterparties

### Box 3. Growing Importance of Lender of Last Resort for Central Clearing Counterparties

### Background and policy context
- The 2009 G20 requirement that all standardized OTC derivatives should be centrally cleared has increased the importance of liquidity backstops for CCPs.
- The GFC exposed weaknesses in the OTC derivatives markets—size, interconnectedness, and lack of transparency—that aggravated financial stress.
- Subsequent regulations cited include the Dodd-Frank Act (U.S.) and the European Markets Infrastructure Regulation (EMIR), which require central clearing of standardized OTC derivatives contracts and thereby increase volumes cleared through CCPs.
- The Financial Stability Board’s (FSB’s) third progress report on the implementation of the OTC derivative markets reforms outlines “four safeguards for a resilient and efficient global framework for central clearing”, one of which is “appropriate liquidity arrangements for CCPs in the currencies they clear” (p.3).35
- The Economic Consultative Committee (an informal group within the Bank for International Settlements (BIS)) states that CBs are working towards a regime that ensures there are no technical obstacles for the timely provision of bilateral LOLR by CBs to solvent and viable CCPs, without pre-committing to the provision of this liquidity.36

### Central bank arrangements and examples
- Several central banks (CBs) have arrangements to provide CCPs access to standard operations:
  - Eurex Clearing (Germany) and LCH. Clearnet SA (France) have a banking license, giving access to “normal” CB liquidity.
  - The Bank of England (BOE) implemented in November 2014 an extension to its Sterling Monetary Framework to broker dealers and to central counterparties.
  - Other CBs that can provide LOLR to CCPs include the Sveriges Riksbank and the Swiss National Bank.

### Solvency and viability: conceptual framing (IV. SOLVENCY AND VIABILITY)37
- LOLR is traditionally associated with solvent but illiquid banks; the aim is to support a viable bank and provide breathing-space to restore normal functioning.
- The approach may read across to CCPs, less easily to SDs, and not to agent-intermediaries.
- Differentiating liquidity from solvency problems in a bank is not easy in practice.38

### Assessment challenges in crisis times
- Illiquidity is relatively straightforward to identify—banks being unable to meet payments due—but in crisis times illiquidity and solvency issues tend to become inextricably linked, complicating solvency assessment.
- Three main reasons the assessment of solvency can be difficult:
  - First: In crisis times mark-to-market values can become extremely volatile, making true solvency assessment difficult. Forced asset sales can turn illiquidity into insolvency. Example: Lehman Brothers’ liquidity crunch and the Fed’s asset valuation timing. Similarly, when Eurosystem LOLR was extended to Greek banks in 2011, assumptions regarding the solvency of the Greek sovereign were crucial as the banks receiving LOLR were large holders of Greek government bonds.39,40
  - Second: Valuation of non-tradable assets (e.g., loans) and collateral (e.g., commercial property, or industrial inputs funded by short-term commercial bills) may lie beyond the CB’s scope of expertise and can be significantly impacted by macroeconomic or sociopolitical shocks.
  - Third: BIS (2014) suggest scope for solvency assessments by supervisors or analysts to be biased; supervisors may wish to avoid reputational risk of identifying insolvency ‘under their watch’ and potential systemic consequences.41

### Dynamic and forward-looking assessments
- CBs are reexamining LOLR solvency requirements. The Bank of Canada’s 2015 consultation paper considers replacing a solvency requirement with a requirement for the entity to have a credible recovery plan (i.e., a demonstration of viability) and resolution framework.
- In some cases solvency assessment is embedded in LOLR legislation; standard solvency assessment can form part of CB consideration even if not strictly adhered to.
- Operationally, compliance with regulatory ratios could be a starting point, but judgment could include qualitative elements such as market perception of the institution.
- Distinguish between:
  - “Point in time” assessment: solvency assessed at time of application for liquidity support—likely based on the most recent available supervisory data reports.
  - “Forward looking” assessment: expected solvency assessed over the near-term, recognizing that an institution may suffer continued losses and become insolvent during a liquidity support operation.
- Forward-looking concerns may derive from exposure to sectors likely to underperform in near term (examples: hotels and restaurants in a region shunned by tourists; a business bypassed by technological innovation).42

### Viability considerations and indicators
- A viability assessment is “business model”-focused to determine the recipient’s potential for generating sufficient cash flow to repay LOLR; a bank with sufficient capital today but expected to run future losses would not be viable.43
- Indications of non-viability could include:
  - A business model that relied on the ready availability of cheap short-term funding and a positively-sloped yield curve—conditions that may have disappeared in a post-GFC environment of increased market risk aversion and a flattening of the yield curve.
  - An entity with poor corporate governance structure and/or a poor risk management culture.44
- Funding asset management companies that could take years or decades to run down an asset portfolio is viewed as a fiscal rather than a central banking task; such situations call for plans to transfer deposits and performing assets to another entity (a bridge bank).45

### Operational and policy implications for LOLR to CCPs
- Where short-term bilateral LOLR might be extended in the absence of other viable funding alternatives, state support—implicit or, preferably, explicit—may provide CB comfort for short-term extension.
- In such scenarios, in addition to general eligibility criteria, ex ante agreements should address:
  - The extent of restructuring.
  - Establishment of strict timelines for conclusion of restructuring.
  - The ability to impose conditionality.46

*Source: _wp1610 - Box 3. Growing Importance of Lender of Last Resort for Central Clearing Counterparties*

### Box 4. Lender of Last Resort and Resolution

### Box 4. Lender of Last Resort and Resolution

### Overview
- From a theoretical perspective it may make sense to immediately resolve a failed bank; but practically it may not be straightforward. In most countries, the legal framework for orderly resolution, and the planning and other reforms necessary to make it effective, are not yet fully in place and the failure of an (insolvent) bank may trigger financial instability. CB funding of insolvent banks is a break from past convention and may exacerbate moral hazard effects.
- In certain limited cases bilateral LOLR may be needed as a temporary backstop—for example, while plans to create a bridge bank or recapitalize the failed entity are put into effect.
- Where bilateral LOLR is considered, in addition to the usual requirements attached to LOLR, central banks should consider the specific safeguards and operational constraints listed below.

### Conditions and safeguards for bilateral LOLR
- Corporate operations should be restricted to core activities, while efforts are undertaken to ascertain the likely prospect for recapitalization or restructuring.47
- In the absence of realistic time-bound recapitalization or resolution plans the entity should not be supported.48
- Insolvent banks and banks with capital levels below the minimum regulatory requirements should not be eligible for monetary policy operations; however, prohibition from monetary policy operations needs to be carefully managed to allow continued access to payment and settlement systems and communicated to avoid the risk of provoking a deposit run.
- Bilateral LOLR to entities which may not be solvent should be fully indemnified by the government, in order to protect the CB balance sheet. This is particularly important as, in the absence of an indemnity, the CB may be forced to monetize any losses associated with the provision of liquidity support—endangering the effective implementation of monetary policy.
- In limited circumstances when financial stability needs to be preserved and with adequate safeguards, a CB may need to provide liquidity support to entities that while insolvent are seen to be viable—for example, where the CB has received comfort from the fiscal authorities that the institution will be recapitalized at a predetermined date in the near future, and that it has a viable business model longer-term.49
- Under such circumstances it may be reasonable that LOLR could be extended to systemic entities whose solvency concerns will be resolved with certainty and within a short time frame;50 and the CB could require an indemnity from the government to protect its balance sheet.

### “Systemic-ness”
- Argument: LOLR should be provided for financial stability purposes or only to systemically important institutions (SIBs or SIFIs). This aims to avoid putting public funds unnecessarily at risk but can create moral hazard—the ‘Too Big to Fail’ problem—as only SIBs and SIFIs benefit.
- Practical considerations:
  - The failure of a small bank during “normal” times may not be systemic, but during a period of heightened tension its failure may well be.
  - Letting a bank judged solvent and viable fail (e.g., because it is not as big as other banks) can be costly if contagion risks arise.
  - Supporting a bank may be cheaper than resolution, making the case for supporting all regulated banks that are clearly not insolvent and are viable.
- Jurisdictional approaches:
  - Most CBs can lend to all regulated banks, systemic or not. The Eurosystem takes potential systemic consequences into account when idiosyncratic LOLR is considered by national CBs (ECB, 2013). Some euro zone jurisdictions (e.g., Ireland and Finland) reference preserving financial stability. A few CBs (e.g., the Swiss National Bank) distinguish eligible banks by systemic importance among other criteria.51
  - Confining LOLR to systemically important banks may raise equal-treatment issues and extend an implicit subsidy to these entities. Fixed-point systemic determinations may suffer time-consistency problems because even relatively small banks can be systemic during periods of heightened depositor concern.
- Recommended framework for assessing systemic importance (CBs should develop frameworks reflecting intrinsic features and circumstances):
  - Size: market share of deposits and lending; activity in the interbank market; importance in the payment system (volume and geographical reach).
  - Complexity: higher complexity may increase the risk of disorderly resolution and unforeseen problems.
  - Services provided: uniqueness or limited provision by other institutions.
  - Interconnectedness: bilateral exposures (e.g., derivatives), or capacity to magnify shocks and cause turbulence in asset markets (leverage).
  - Risk of contagion: wholesale or retail deposit runs, or fire-sale of assets.52
- Operational requirement: CBs should adopt arrangements, including information and data collection, to allow quick assessment of systemic importance at short notice and run systemic impact assessments to decide LOLR eligibility. Some indicators will be subjective, and judgment is unavoidable.53

### Tackling fire sales
- Fire-sales drivers:
  - Sales to obtain cash (e.g., to meet margin calls, near-term payments). Lending against the asset (e.g., an asset swap) may meet the investor’s requirement and could be more effective than lending reserve money.
  - Sales to limit exposure to further price falls. Lending against the asset may not help because the investor’s goal is an outright sale; finding a price acceptable to sellers and the CB may be difficult. CB purchasing at market price can involve considerable credit risk; acting as “market maker of last resort” in stressed circumstances could amount to “purchaser/underwriter of last resort.”
- Recourse versus non-recourse lending:
  - Standard CB lending is collateralized with recourse to the borrower—the borrower’s liability is not affected by collateral performance. This provides cash but does not change the borrower’s credit exposure.
  - Non-recourse lending with a suitable haircut can address the credit-risk aspect of fire sales. Example mechanism:
    - If asset price has fallen X percent, CB lends on a non-recourse basis at a penalty interest rate, with a haircut of a further Y percent to the distressed market price. The investor receives cash equivalent to (100-X-Y) percent of the pre-crisis price and is exposed to a maximum Y percent further price fall.
  - Non-recourse lending exposes the CB to credit risk if asset values fall persistently; recommended that CB be fully indemnified by the government for these operations.57
  - Determining appropriate haircuts is difficult but critical: too large a haircut may inflict excessive perceived losses and fail to prevent fire-sales; too low a haircut puts excessive risk on authorities and increases moral hazard.
  - Combined approach: offer both recourse and non-recourse lending for a given asset class (if systemic response warranted). Example pricing structure:
    - (i) Recourse lending at the policy rate plus 100 basis points (bps) and an X percent haircut.
    - (ii) Non-recourse lending at the policy rate plus 150 bp, a fee of 25 bp and a haircut of 2X percent.
  - Non-recourse lending is similar to selling a put option; if prices do not fall as feared, borrowers have incentive to repay and retrieve collateral. Alternatively, the CB or government could sell a put option instead of non-recourse lending to address price risk without injecting reserve money.
- Operational channeling: To avoid managing a large number of new counterparties, a scheme could operate via banks that are existing CB counterparties—allowing a bank customer to borrow non-recourse from its bank and the bank to mirror-borrow from the CB on the same terms.

### Key operational challenges
A. Short-term or Long-term?
- Duration of support should reflect root cause and not be longer than necessary. He (2000) suggests reliance on CB assistance for longer than a few weeks indicates more acute difficulties (e.g., insolvency) may be masked by continued idiosyncratic support.
- Some CBs address idiosyncratic needs for as short as a week, reviewed and rolled week to week; other CBs operate under or announce limits between one month and three months.59
- The GFC showed liquidity problems in otherwise viable banks may persist for several months and even years where market fragmentation and unresolved asset-quality problems remain. This may require flexibility; in the euro zone some banks benefited from LOLR support some six years after the start of the crisis.
- Time-limited provision is desirable to discourage market perception of open-ended facilities, provide review points, and encourage supervisors/resolution authorities to resolve troubled entities if recovery is not foreseeable in a reasonable time-frame.60
- Inclusion of binding maturity limits in LOLR legislation requires careful consideration: too long invites political pressure to extend lending; too short may constrain CB flexibility.
- Funding plans should be developed early with the supervisor to establish likely liquidity need scale and a clear end-date. Institutions should demonstrate a reasonable prospect of repaying liquidity on or before maturity. Funding plans must have clear, verifiable targets; failure to meet them should trigger escalating supervisory actions. Initial LOLR loans could be short maturities pending approval of a plan; failure to provide a plan should carry resolution consequences.

B. Cost
- Approaches to pricing LOLR vary:
  - ECB: said to apply a fixed spread over the CB’s overnight lending facility.61
  - HKMA: establishes rate as policy rate plus a spread taking into account current market conditions; Bank of Canada has charged its bank rate.62
  - BOE: suggests the rate should not be fixed but dependent on circumstances and counterparty; recommends a high fee to discourage use and minimize moral hazard while not being so high as to accentuate strains.63
- Alternative pricing approach: charge a high rate at the outset and reduce it over time—the “reduction approach”—using high rates for short-term LOLR (e.g., up to one month) to deter use when alternatives exist, and a lower penalty rate for longer-term needs due to increased supervisory scrutiny and to avoid exacerbating problems.
- Applying “market rates” is problematic: no genuine market rate may exist for an illiquid institution—if funds were available in the market, the institution should not need LOLR. CBs must balance incentives to seek alternative funding against moral hazard if LOLR is too cheap.
- In systemic lending (“emergency” or “exceptional” liquidity assistance), the lending rate cannot be penal since it determines short-term interest rates. The CB could raise its policy rate, constituting monetary policy tightening, which may or may not be appropriate depending on broader macro conditions.

C. Adequate collateral
- Standard of collateral in idiosyncratic responses differs from systemic responses. Systemic needs often reflect a blockage preventing collateral use rather than an issue with collateral itself.
- In idiosyncratic liquidity needs, institutions may have exhausted high-quality assets; the CB may need to accept many types of unencumbered assets provided:
  - (i) ownership can be legally transferred;
  - (ii) it can be priced;
  - (iii) the asset, including associated risks, can be managed by the CB.64
- Bagehot’s principle of lending only against “good” collateral may not always be feasible for bilateral LOLR, but collateral accepted should always be adequate to cover anticipated losses at that point in time.

*Source: _wp1610 - Box 4. Lender of Last Resort and Resolution*

### Appendix III provides guidance on key issues CBs may face when considering what

### _wp1610 - Appendix III provides guidance on key issues CBs may face when considering what

### Collateral acceptance and due diligence
- Central banks (CBs) must ensure they have good legal title to collateral; without legal title, liquidity provided is essentially equivalent to an unsecured loan.
- Thorough due diligence should be undertaken before collateral is accepted, along with ex post verification checks.
- Handling and administrative costs are important considerations in collateral choice:
  - A portfolio of loans to small and medium-sized enterprises may have low credit risk but be illiquid and cumbersome to manage if mobilization is required.
  - In some jurisdictions, taking and using loan book collateral is legally difficult or impossible (example: the Civil Code in Russia at one stage limited the use of such collateral).
- As part of recovery and resolution planning, authorities should consider pre-positioning collateral (for example, amending loan documentation to facilitate title transfer).
- Practical constraints in some jurisdictions:
  - Debtor notification and/or approval may be required before loan assets can be used as collateral.
  - Local custom may make it practically impossible to take possession of residential property collateral.
- Prepositioning of collateral allows the CB time to examine documentation and conduct valuations before collateral is used.

### Indemnities
- Idiosyncratic LOLR involves lending to illiquid institutions generally against lower quality collateral, putting public funds at risk.
- The CB could consider seeking a government indemnity when there are concerns about:
  - quality of the counterparty (e.g., solvency is not clear),
  - the collateral presented,
  - the size or length of support,
  - the exit strategy.
- The indemnity obligation should:
  - undertake to make good any CB losses associated with the provision of LOLR,
  - be unconditional and irrevocable,
  - be callable on demand by the CB.
- The CB should devise and agree on a procedure with the Treasury as to when government guarantees would most likely be sought.
- Alternative: government could undertake to recapitalize the CB should its capital fall below a given threshold or turn negative.
  - The CB could take losses up to the point where capital falls below a predetermined level.
  - A general undertaking without an exact period for completion is insufficient.
  - Any recapitalization should be by way of marketable securities, carrying market rates of return, and ranking pari passu with other government obligations.
  - Use of long-term government securities with low rates of return and limited tradability has in practice produced net present values far below required recapitalization levels in some cases.
- Losses could be made good over time through retention of all, or a portion of, future profits to be distributed to the State; however, future profits may be uncertain.
- Credit rating agencies are increasingly focusing on contingent liabilities from public sector support; provision of an indemnity could be credit negative and may increase market funding costs or, in extreme cases, result in loss of market access.
- Possible competition issues associated with fiscal guarantees are noted elsewhere in the source.

### Supervisory response — Domestic institutions
- Increased supervisory intrusion and conditionality is a necessary prerequisite for bilateral LOLR.
- The supervisor should enhance oversight and adopt early intervention measures; supervisory powers should allow prompt corrective actions.
- Conditionality could include:
  - asset sales,
  - a bar on distribution of profits and payment of bonuses,
  - changing management,
  - other measures to address governance and risk management failures.
- Recipient institutions should be subject to a binding funding plan, drawn up early between the CB and/or supervisory authority and the institution:
  - The plan should project assets and liabilities at least one year out.
  - Include anticipated roll off from the asset portfolio, upcoming bond and interbank redemptions, and anticipated deposit flows.
  - Be updated regularly and include stress assumptions (examples: flows from a rating downgrade, roll-over rates of deposits, interbank activity and bond maturities).
- CB and regulatory authority should engage at least on a daily basis with the bank and receive daily or intra-daily liquidity updates.
- Conditionality/remedial actions may include binding requirements for deleveraging, asset and liability transfers, restructuring, forbidding dividend payments, and approval for increases in staff salaries.
- Institutions should be mandated to use provided liquidity only for core business (e.g., honoring previously-granted overdraft facilities) and not to extend non-core or risky lending.
- Close attention should be paid to significant changes in the composition of the bank’s asset portfolio.
- LOLR operations should not be used for capital management exercises such as debt buybacks; calling debt ahead of term is a capital management technique and should be treated accordingly.

### Supervisory response — Cross-border banks
- Increased supervisory intrusion and conditionality is more complex for cross-border entities due to distinctions between subsidiaries (legally separate) and branches (extensions of the parent).
- Host authorities may lack information and intervention powers if branches operate under home authority licensing and supervision.
- Two main risks when lending to entities in cross-border groups:
  - Up-streaming of funds: funds provided locally may be passed to head office abroad, leaving domestic creditors unprotected.
  - Parent withdrawal of support: liquidity need could stem from parent stopping support due to parent weakness, local balance sheet concerns, local currency depreciation, or sovereign debt restructuring (example: 2010–11 Greek banks operating in Bulgaria and Romania faced liquidity problems when the parents required LOLR support).
- Methods to mitigate central bank risks when lending to subsidiaries/branches:
  - Evidence from the parent that alternative funding cannot be sourced from other parts of the banking group or from the home CB.
  - An MOU between the home and host CB (or supervisory authority) for sharing of prudential information.
  - A determination that the foreign bank operation is systemically-important in the host jurisdiction.
- Terms and conditions for provision to foreign-owned entities should allow for full oversight and sanctions for non-compliance (e.g., with intra-group transactions).
- Possible measures include ring fencing assets and liabilities of the local institution to:
  - prevent relocation of high quality assets to the parent,
  - ensure liquidity provided remains within the jurisdiction,
  - avoid the need for further liquidity provision by the host CB.

### Foreign currency lender of last resort (FX LOLR)
- FX LOLR may be needed when the financial system is “partly-dollarized” or the financial sector is reliant on cross-border FX funding.
- Emergency lending has generally been provided only in domestic currency based on the premise that commercial banks manage FX risk, but that premise has been challenged since the Global Financial Crisis (GFC).
- During the GFC, large banking-sector exposures to FX risk combined with a sudden global tightening of FX liquidity required some CBs to provide FX support beyond usual practice.
- Such support is normally limited due to CBs’ finite FX supplies; FX LOLR during the GFC was conducted in response to systemic need rather than bilaterally.
- CBs with limited or no available FX resources face particular difficulty meeting FX liquidity needs (especially highly dollarized countries or currency board regimes).
- Some CBs entered into currency swap agreements during the GFC; not all CBs had access and some used their own FX reserves.
  - Example numeric reference: Some 14 CBs borrowed USD via currency swaps with the Fed, and some European CBs engaged in swaps and repos with the ECB.
- The IMF is including consideration of potential FX LOLR needs when estimating appropriate official FX reserve levels (see IMF, 2015).
- For fully “dollarized” countries, consider earmarking government funds for bilateral LOLR support (example: Kosovo); other options include a dedicated contingency fund financed by banks.
- Policy measures to reduce systemic or idiosyncratic FX liquidity risk:
  - Supervisor could tighten FX prudential liquidity requirements as FX risk grows and monitor liquidity mismatches by major currency groups, identifying cross-border exposures.
  - Macro-prudential authority could consider measures such as system wide limits (for example as a percentage of capital) on FX loans to un-hedged borrowers, or levies on FX deposits.
- Preparatory steps before providing bilateral FX LOLR:
  - The CB should quantify the scale—and currency denomination—of the likely FX need by examining bank balance sheets and assuming e.g., a non rollover of X percent of short-term FX liabilities; match this against available FX resources including official FX reserves and existing currency swap lines.
  - The CB should investigate realistic options to increase FX availability (for example, establish or increase currency swap lines with other CBs or international authorities; incentivize foreign parent banks to provide or maintain FX funding to subsidiaries/branches).
  - Authorities might consider quantitative restrictions on the amount of FX support banks can obtain (explicit hard limits as a function of bank size or implicit internal guidance). Announcing limits may restrict CB response and may not be time consistent; it may be preferable to announce that FX liquidity provision would be restricted and only made under exceptional circumstances.
  - As a last resort, the CB may consider administrative controls such as ring-fencing FX deposits, deposit conversion, or deposit restrictions; these controls have been used to prevent large drains on limited FX reserves but may have significant financial stability implications.

*Source: _wp1610 - Appendix III provides guidance on key issues CBs may face when considering what*

### introduction should only be considered when other possible avenues have been

### _wp1610 - introduction should only be considered when other possible avenues have been

### VII. KEY OUTSTANDING CHALLENGES — Central Bank Autonomy
- Principle: CBs should not assume LOLR risks so large that realized losses would undermine public confidence (Moe (2012), p. 31).
- Some CBs are reviewing emergency arrangements and being more prescriptive about intervention to balance financial stability and CB autonomy (IMF, 2014).
- CBs should retain some element of discretion because emergency interventions involve judgment and unpredictability (Winters, 2012).
- Uncertainty: It is not clear ex ante how much a CB can lose without threatening independence.
- Sovereign indemnity issue: If the sovereign—with “long-run deep pockets”—is unable or unwilling to indemnify LOLR, the CB—with only “short-run deep pockets”—may endanger long-run financial stability by assuming such burdens.

### VII. KEY OUTSTANDING CHALLENGES — Competition Policy
- Public-fund nature: Idiosyncratic liquidity support uses public funds and could be seen as a state function rather than a CB function.
- Competitive advantage risk: A company receiving state support (e.g., government guarantee or LOLR funds) could secure ‘cheaper’ funding and avoid exit, distorting the level playing field.
- Timing risk: Competition laws or compliance processes with long decision horizons or narrow mandates could undermine LOLR effectiveness if deployment is too slow.
- European Commission approach:
  - Interpretation allowing that LOLR granted at the CB’s initiative, at a suitably high rate and to illiquid but fundamentally solvent entities, is not state aid. 83
  - CB lending to potentially insolvent entities, or under-collateralized lending and/or lending indemnified by the state, is considered state aid and could trigger formal and lengthy proceedings by the Commission. 84
- Recommendation: Given high economic cost of systemic crises, competition policy frameworks should not overly restrict CB flexibility to provide LOLR. If competition rules apply, exemptions and accelerated procedures should exist where financial stability is threatened.

### VII. KEY OUTSTANDING CHALLENGES — Public Banks
- Public banks in principle should be eligible for LOLR, but authorities should continuously assess why alternative liquidity sources are unavailable.
- In some circumstances—when sovereign lacks easy access to capital markets—it may be preferable for the CB to provide lower-cost bilateral support to state-owned institutions, but:
  - The support should be no lower than LOLR provided to private sector banks.
  - Benefits to the government:
    - Costs of lending will most likely be passed back to the government, but with a delay, per profit redistribution protocols.
    - When government funding is limited, fiscal authorities may prefer CB funding of state-owned banks rather than the bank competing in private funding markets (and competing with treasury funding).

### VIII. SUMMARY AND CONCLUSIONS — key findings and propositions
- Variation: Central banks’ approaches to LOLR vary considerably, shaped in significant part by responses to the GFC.
- Bagehot’s principle: Classical view is that LOLR should support temporarily-illiquid but solvent banks; applying Bagehot at an operational level in the modern financial and regulatory environment is complex.
- Paper’s arguments (bullet list preserved from source):
  - There are instances where the provision of LOLR funds to some non-banks is warranted, but careful consideration needs to be given to the reasons for doing so and the way in which the support is structured. Idiosyncratic LOLR for NBFIs is unlikely to be appropriate, except in the case of systemically-important CCPs. As a contingency, CBs may benefit from having statutory powers in place to lend to regulated and supervised NBFIs in exceptional circumstances. If the exceptional liquidity demand of non-banks has arisen as a result of market inefficiencies or regulatory loopholes, policies should be put in place to limit or prevent these arising again in the future.
  - System-wide problems in NBFIs may also justify a system-wide response to prevent asset fire-sales, which may have damaging consequences for financial stability. Tackling asset fire-sales is a difficult task and will most likely involve the CB (or government) accepting additional risk. Non-recourse lending (or, possibly, the sale of out-of-the-money put options) may offer an effective tool to address these problems without creating excessive moral hazard. But this is not market making, in the sense of making a two-way price and expecting to trade in both directions: the authorities are more likely to become “buyer of last resort” and—if so—should be clear that this is the case.
  - Solvency requirements remain a key component of LOLR when applied on a forward looking basis, and should complement the viability assessment of the institution. There is a strong argument to be made for lending to all regulated banks which are judged not to be insolvent, are able to provide collateral and—importantly—are seen as viable. But a business which is not viable should be wound down, even if it is solvent today.
  - While LOLR support is intended to be temporary, the use of published time bound maturity limits can “tie the hands” of a CB in an unhelpful way. It proposes that the maturity of LOLR support only be as long as the underlying liquidity need, while the counterparty should at all times demonstrate a credible prospect of repaying the operation on or before maturity.
  - An appropriate balance has to be found in terms of pricing, both the interest rate and any fees: the cost should be high enough to encourage banks to seek other forms of funding—including obtaining additional capital—but not so high as to exacerbate liquidity strains and make survival of the institution (and repayment of LOLR) less likely.
  - Regulatory intervention and conditionality may be seen as an important element of the costs imposed on LOLR beneficiaries. Effective regulatory intervention and conditionality may be difficult in the case of NBFIs, and also foreign branches or subsidiaries of foreign banks.
  - The ability to provide FX liquidity is an important safety net in many markets. For the majority of CBs, their ability to meet FX liquidity needs will be constrained and this should be clearly communicated to the market. Prudential or macroprudential measures may have a role in reducing potential FX calls, but are unlikely to eliminate them entirely.

### APPENDIX I. OVERVIEW OF SYSTEMIC AND IDIOSYNCRATIC RESPONSES TO THE GLOBAL FINANCIAL CRISIS IN THE THREE MAJOR CENTRAL BANKS
- Timing and actions:
  - When the GFC broke, three major CBs (the U.S. Federal Reserve, the ECB, and the BOE) responded by increasing the supply of reserve money to meet a liquidity need—and only later on by cutting their policy rates (in many cases close to the zero lower bound) in response to monetary policy needs. They adopted a series of unconventional monetary policy actions in response to systemic and idiosyncratic liquidity needs.
- Counterparties:
  - Some CBs permitted existing counterparties to access new facilities or expanded counterparty lists.
  - U.S. Federal Reserve measures:
    - Created the Term Auction Facility (TAF), available to all depository institutions, expanding beyond Primary and Secondary Credit Facilities (PCF and SCF) known jointly as the ‘Discount Window’, and extended the maturity of the PCF. 85
    - Created the Primary Dealer Credit Facility (PDCF) for securities dealers.
    - Under Section 13.3 of the Federal Reserve Act, a line of credit was extended to a non-bank subsidiary of AIG, and support provided to certain other non-banks (facilities later terminated once markets stabilized).
  - BoE measures: put in place arrangements to extend monetary policy framework beyond banks to certain central clearing counterparties and particular broker dealers. 86
  - ECB: engaged with a large number of eligible credit institutions and did not expand its counterparty framework during the GFC.
- Instruments:
  - Notable development: U.S. Federal Reserve bilateral swap lines with some developed-country and emerging-market CBs:
    - In December 2007 the Fed announced reciprocal currency arrangements to provide dollar liquidity overseas; lines were authorized for fourteen foreign CBs.
    - Swap lines allowed non-U.S. CBs to supply domestic markets with potentially unlimited quantities of dollars.
    - Principle: home CB should provide liquidity to banks under its jurisdiction against domestic collateral (CGFS, 2008).
    - Other bilateral FX arrangements included a swap between the Central Bank of Ireland and the BOE. 87
  - Asset swap operations provided liquid assets without creating reserve money:
    - U.S. Federal Reserve Term Securities Lending Facility (TSLF) and BOE Special Liquidity Scheme (SLS) swapped illiquid assets against treasury securities.
  - ECB operations:
    - Announced fixed-rate full allotment OMO policy in September 2008 and extended maturity of some operations to three-year operations (LTROs) to provide funding certainty.
    - Some Eurosystem CBs responded to idiosyncratic emergency liquidity needs at their own risk (Bindseil (2014), p. 247). 88
- Collateral:
  - Since 2008, BOE and ECB expanded collateral frameworks, accepting assets not previously eligible by type or credit quality.
  - BOE announced measures to enable greater market dynamism: offer funds for longer periods indexed to the policy rate, lower cost of using facilities (notably for lower quality collateral), and accept a wider range of collateral, including “any asset of which we are capable of assessing the risks.” 89

### APPENDIX II. DESIGNING A FRAMEWORK — Interaction with the Market
- Ex ante disclosure: two general CB approaches to describe idiosyncratic response frameworks. 90
  - “Rules-based” approach: CB explicitly states requirements and operational parameters for LOLR (preconditions; CB discretion; terms and conditions including tenure, eligible collateral, pricing; remedial actions and supervisory response). Pros and cons:
    - Pros: conditions market behavior (e.g., maintaining prudent unencumbered LOLR-eligible assets); reduces pressure to extend LOLR to ineligible entities.
    - Cons: more prescriptive frameworks risk being “time inconsistent”; predefined caps (e.g., fixed ratio limits) could exacerbate creditor runs. 91 92
    - Examples of use: Hong Kong (policy statement), Montenegro (Board decision), Bank of Canada (guidance note).
  - “Constructive ambiguity” approach: pre-conditions and operational arrangements are not (fully) disclosed. Pros and cons:
    - Pros: greater freedom to tailor responses; avoids disclosing limits which could amplify runs.
    - Cons: less transparency; market uncertainty; potential questions about outside authorities’ influence; taxpayers may demand disclosure. 93
    - Examples of use: Eurosystem countries, Russia, New Zealand, Norway.
  - Practical advice:
    - When designing LOLR frameworks, CBs should not overly restrict response flexibility. Flexibility is important because published limits can be problematic from a time consistency perspective and destabilizing.
    - CBs not following rules-based approaches could consider disclosing key aspects (without pre-commitment) such as approach to solvency/viability tests and categories of acceptable assets to inform market contingency planning.
- Ex post disclosure:
  - Historical practice: CBs disclosed little about LOLR operations, but pressure for disclosure has increased.
  - Risks of concurrent disclosure: providing information concurrently may confirm creditor concerns and exacerbate deposit runs. 94
  - Accountability: Ex post disclosure is needed to ensure accountability because public resources are used for bilateral LOLR. CBs should prove actions were within rules and mandate and should undertake ex post assessments of operations with recommendations for improvement. 95
  - Timing and nature: Careful timing recommended; best practice is ex post disclosure with appropriate time-lags. Names of institutions generally should not be disclosed; premature disclosure can undermine policy objectives. 96
    - Example: U.K. disclosure of liquidity support to Northern Rock precipitated a retail deposit run; stopped only after a government guarantee.
    - U.S. Dodd-Frank introduced delayed disclosure mechanisms: loans from regular discount window or OMOs disclosed approximately two years after operation; operations under 13.3 disclosed one year after authorization termination.
  - Sterilization considerations:
    - Whether to sterilize depends on policy objectives and risks. Bilateral LOLR can depress short-term rates by creating excess reserves. 97
    - If monetary policy does not want rate reduction, sterilization may be necessary, but sterilization operations can highlight the provision of LOLR. 98 99
    - Asset swaps do not create reserve money and thus do not require sterilization.
    - Example: Eurosystem three-year LTROs created reserves in excess of system demand; no urgent need to absorb additional liquidity as ECB wanted to ease monetary conditions. 100 101
- Disclosure and stigma:
  - Stigma: “The stigma attaching to a bank needing to resort to [bilateral LOLR] is an important safeguard against moral hazard” (Plenderleith, 2012, p. 75). 102
  - Balance: Stigma should not be so strong as to render policy ineffective; CBs should provide comfort to sound counterparties so they are not restricted from approaching the CB when facing temporary liquidity pressures, although access should not be a right.
  - Confidentiality: Participating institutions should have certainty on confidentiality and disclosure policies and be comfortable they will not be “named and shamed.” However, it may not always be possible to disguise use of bilateral LOLR and market awareness may provoke media scrutiny or “witch hunts.” 103

*Source: _wp1610 - introduction should only be considered when other possible avenues have been*

### Appendix IV discusses further the use of OMOs as a means of possibly reducing stigma.

### _wp1610 - Appendix IV discusses further the use of OMOs as a means of possibly reducing stigma.

### Stakeholder coordination: establishing roles and responsibilities
- Central banks (CBs) have operational responsibility for the provision of LOLR support—to the extent such support requires the provision of CB money—due to their monopoly over reserve issuance within its own jurisdiction.
- The CB is operationally best suited to handle the provision of collateralized lending given its interaction with the market through regular monetary policy operations and familiarity with the operational aspects associated with collateralized lending.
- Well-designed rules and agreed operational procedures for LOLR support defined ex ante among stakeholders—namely, the CB, the treasury, domestic, and foreign supervisors—can permit the authorities to act swiftly when required.
- Documented rules and procedures help limit the risk of political pressure on the CB, where the CB may be directed to lend, at its own risk, to entities or against collateral it would not otherwise be prepared to do.
- CBs should regularly perform testing of LOLR processes and have reliable contingency operational arrangements.
- CBs should establish an internal working group to facilitate sharing of information, formulation of procedure documents, and testing schedules so all parties understand respective roles.

### Role of supervisors and assessment responsibilities
- Key reliance is placed on the supervisor to anticipate, assess, and monitor liquidity needs; enhanced supervisory oversight and early intervention distinguish LOLR from other operations.
- Supervisor responsibilities include:
  - Ex ante monitoring of banks’ funding flows and assessment of adequacy and eligibility of collateral holdings and potential LOLR drawdown requirements.
  - Determination of solvency and viability.
  - Formulation of funding plans upon which ongoing provision of LOLR is dependent.
  - Ex post compliance with funding plans.
- Cross-border arrangements for cooperation, coordination, and exchange of supervisory information may be required depending on the institution.

### Decision-making, legal frameworks, and indemnities
- The decision-making process and risks associated with lending can be retained by the sovereign; example: in the U.K. a Triparty MOU divides responsibilities between the BOE, the Prudential Regulation Authority, and the chancellor and treasury.
- In certain circumstances the BOE can provide certain lending outside the BOE’s liquidity provision framework on behalf of the government but is fully indemnified and acts as the treasury’s agent.
- For countries under currency board arrangements, provision of reserves by the CB is prohibited except where the CB has free reserves over and above the binding level of foreign reserves (typically 100 percent of base money). Absent these excess reserves, provision of support to the financial system falls under government responsibility.
- Tasks for stakeholder coordination (Table 3; tasks listed with lead roles where indicated):
  - Scale of LOLR requirement and overview of recent liquidity developments. — Supervisor & Market Operations Area.
  - Assessment of systemic impact (where relevant). — Supervisor (L) & Market Operations Area.
  - Good governance assessment—‘fit and proper’. — Supervisor (L) & Market Operations Area.
  - Solvency & viability assessment. — Supervisor (L) & Market Operations Area.
  - Collateral availability, eligibility assessment of collateral pre-positioned, risk controls and valuation. — Market Operations Area (L), Legal and Supervisor.
  - Exit/funding plans and conditionality. — Market Operations Area (L), Supervisor, Legal.
  - Preparation of mobilization agreement. — Legal (L) & Market Operations Area.
  - Communication. — Communications Area (L), Fiscal Authority, Supervisor, Individual Institution.
  - Indemnity. — Market Operations Area and Fiscal Authority.
  - Decision. — Central Bank Board.
- Depending on operational capabilities, the government or other entities may request the CB—as honest broker—to carry out operational aspects of market solutions on their behalf.
- Some countries, such as the U.K., Denmark, and Australia, have established MOUs to define roles and procedures.
- Where the CB lends on behalf of the government, clear indemnity and legal constraints are necessary to limit CB exposure and to specify when lending is conducted as the Treasury’s agent.

### Stigma risks and operational labeling
- Stigma concerns can exist for regular monetary policy operations; regulatory, disclosure, or other consequences can prevent sound counterparties from accessing standard monetary policy operations.
- Example cited: in August 2007 Barclays used the Standing Lending Facility for operational reasons and public disclosure led to stigmatization of the facility.

### Alternatives to LOLR (Box 6): examples of funding alternatives and caveats
- Pooling funds:
  - Funds within the banking system may be pooled together, along with government liquidity support and in some cases CB support, administered by the CB (example: Korean liquidity support program for securities dealers in the GFC).
- Government guarantees:
  - The government may guarantee liabilities of a distressed institution (excluding equity and subordinated debt and possibly other liabilities) while a permanent solution is devised; guarantees should be collateralized (for example, by shares) and include a fee.
  - Guarantees create contingent liabilities that may be credit negative and threaten market confidence; a guarantee of a low rated country may not be sufficient to defend an institution from market speculation.
  - Significant moral hazard and fiscal risks arise; careful consideration required.
- Government provision of liquidity:
  - The government may provide liquidity directly as unsecured deposits (most likely for a state institution) or enter into collateralized repurchase agreements with the concerned institution.
  - Such placements should be structured as market transactions and conducted with institutions complying with the government’s own risk control measures.
  - Provision of government support should not be used to avoid enhanced supervisory intrusion, conditionality, or prudent collateral policy measures that would otherwise apply to the CB’s LOLR arrangement.
- Indirect lending:
  - Indirect lending could involve provision of CB funds to eligible counterparties that on-lend to concerned banks.
  - CB funds provided in this way need careful configuration so the CB is not seen to interfere with intermediary institutions’ independent risk assessment; transactions should be on market terms and include safeguards and, at a minimum, a government indemnity.
  - Example: an indirect transaction in Ireland during the GFC.

*Source: IMF Staff (content from Appendix IV of the referenced IMF work).*

### APPENDIX III. COLLATERAL AND RISK CONTROL MEASURES

### APPENDIX III. COLLATERAL AND RISK CONTROL MEASURES

### Overview
- Collateral presented for LOLR is more likely to be less liquid than “good.” Central banks (CBs) should approach acceptance, valuation, and risk control with awareness of operational, legal, and market constraints.
- Regular engagement with the financial system helps CBs understand asset holdings and monitor changes in asset quality and lending practices.

### Collateral acceptance criteria
- When deciding which collateral to accept, CBs could consider assets that have the following traits:
  - Legal certainty—certainty in relation to the transfer of legal title or beneficial interest to the CB which ensures that in the event of a counterparty default, there are no impediments to the CB’s ownership of the asset. For loan portfolios, sample loan documentation should be examined by the CB’s legal area. It is generally easier to mobilize collateral when it is governed by local law rather than foreign law.
  - Central bank status—the CB should understand its status as an investor; for example, whether it is senior or subordinated in terms of the asset’s principal and coupon payments or voting rights.
  - Credit assessment—CBs should, where possible, accept assets for which a credit assessment has been undertaken. This can be performed by rating agencies, “off the shelf” rating tools, or in-house for more advanced CBs.
  - Ease of transferability—ability for the counterparty to transfer the asset quickly to the CB without overburdening registrations or notifications. Consider standardizing loan documentation in normal times to overcome onerous restrictions.
  - Ease of valuation—without deep and liquid markets, the CB may have to procure or develop a valuation approach in-house, which may take time and be costly.
  - Ease of handling—loan collateral handling is more complex than securities (often book entry). CBs would prefer to avoid accepting loans on an individual basis due to operational and legal complexity.
  - Effectiveness—LOLR is emergency support; accepting only a narrow range of collateral limits effectiveness across institutions.
  - Data availability—for loan collateral, knowledge of geographic location, latest valuations, loan to value ratios, monthly repayment amounts etc., is important for assessment.
  - No “close links”—unsecured debt issuances or equities of parties closely related to the counterparty should not be accepted due to “double default” risk. “Close link” relationships could exist in certain securitized transactions and such risks can be mitigated.
  - Diversification—collateral should be diversified to prevent concentration risk.

### Examples of potential LOLR collateral (summary of Table 4)
- Corporate or bank securities
  - Issues: “Close links” between collateral and the borrowing counterparty (double default risk) need assessment; appropriate valuation in an illiquid market may be difficult.
- Securitized assets
  - Issues: Ideally the underlying pool should be transparent; CB should fully understand transaction structure; valuation may be difficult as pay down depends on underlying portfolio performance.
- Residential loans
  - Issues: Mobilization of large quantities of individual loans may be cumbersome operationally, legally, and for risk management.
- Commercial mortgages
  - Issues: Individual commercial mortgages may be large but bespoke agreements create operational, risk management, and legal issues.
- Corporate loans and public sector loans
  - Issues: Mobilization of large quantities of individual loans may be cumbersome operationally, legally, and for risk management.
- Equities
  - Issues: Need to consider (i) appropriate valuation given volatility; (ii) CB’s position as shareholder in event of default; and (iii) ensuring no “close link” or double default risk between equity and institution borrowing LOLR.

*Source: IMF Staff.*

### Loan collateral: key variables and eligibility
- CBs should gather at a minimum information on:
  - Type of loan (residential, corporate etc.)
  - Loan performance (loan-to-value ratios)
  - Credit quality of the loan (assessment by the originator or CB)
- Important eligibility criteria for loans (at minimum):
  - Consent of the borrower for the transfer of the loan
  - A defined level of arrears (which may well be zero)
  - Debtor income verification
  - A defined loan-to-value threshold
  - The type of loan eligible (e.g., annuity loans only)
- Loans present additional challenges because many variables are not publicly available and change with economic conditions.

### Risk tolerance and internal eligibility
- Internally defined eligibility should be established ex ante. CBs should avoid accepting whatever collateral is available with arbitrary haircuts.
- Risk tolerance levels define the main parameters of eligibility and quantify the amount of risk a CB will accept in its lending. This should balance liquidity needs of the system and risks to the CB’s balance sheet.
- Trade-off: imposing penal haircuts increases asset encumbrance (inhibits market funding access) while lower haircuts give less protection to the CB.
- Government indemnities provide comfort but do not negate the need for defined eligibility aligned with CB risk appetite.

### Haircuts
- Purpose: protect the CB’s balance sheet against adverse changes in market value before liquidation or loss when selling illiquid assets into a weak market.
- Haircut methodology should, at a minimum, take into account liquidity, credit, market, valuation, and concentration risks. Additional margin should be applied if other risks (legal, currency) need to be considered.
- No single haircut fits all asset classes; a single methodology is feasible.
- The haircut should reflect that the underlying asset typically will not be realized and will be returned to the counterparty at a later date, while ensuring adequate protection during the operation.

Two-step approach to developing haircut and valuation methodology:
- Phase One—Conservative haircuts
  - Mirror haircut methodology of another CB that accepts similar assets and use an “add-on” to reflect local market specificities and CB risk tolerance.
  - Example: adopt published haircut schedules of the ECB in OMOs with a percentage “add-on” for inferior quality, non-marketability, or FX risk.
- Phase Two—Development of more advanced haircuts
  - Rely on quantitative methods such as value-at-risk, requiring considerable market data to establish liquidity characteristics and price volatility.

### Valuation
- Frequency: aim to value assets regularly at mark-to-market prices; more frequent valuation (ideally daily) lowers potential liquidation price loss. The less frequent the valuation, the higher the haircut should be.
- For illiquid collateral where valid market prices often do not exist, alternative valuation methods are required.

Central Bank Valuation Approaches (summary of Table 5)
- Step 1: Apply the daily market price quoted on service providers such as Bloomberg or Reuters. If there are doubts with regard to the frequency of the prices (should not be stale for more than five days as a rule of thumb) or liquidity in the market, then:
  - Preference: Low
  - Level of sophistication: Low
- Step 2: Apply a theoretical valuation using future cash flows (including call/put options etc) discounted via an appropriate discount rate; rate can use market prices, credit default swap levels and other data. If a complete suite of reliable data or technical expertise is not available then:
  - Preference: High
  - Level of sophistication: High
- Step 3: Imply a price using techniques such as bootstrapping using proxies for unavailable variables (e.g., swap rates). If no reliable proxies available then:
  - Preference: Moderate
  - Level of sophistication: Moderate
- Step 4: Apply face value less an estimated value for any upcoming interest payments expected during the life of the LOLR operation, then increase the haircut by a sufficient amount. For loan collateral this may be the CB’s chosen approach if theoretical valuation is not possible.
  - Preference: Low
  - Level of sophistication: Low

*Source: IMF Staff.*

### Limits
- Introduce limits to avoid over exposure to a counterparty and/or particular collateral, especially absent a government indemnity.
- Borrowing limits
  - Some countries use constructive ambiguity; others have explicit legislative limits.
  - Internal limits are preferred from a risk control perspective; for FX LOLR, disclosure that support is limited may be necessary without public disclosure of the limit.
  - The collateral available can provide an implicit limit, but sovereign guarantees can increase collateral value and change this implicit limit.
- Collateral limits
  - Absolute or percentage limits can prevent over exposure to particular collateral types. Regular monitoring and fall back solutions (e.g., sovereign guarantees) are needed when limits risk being breached.
- Haircut add-ons/valuation markdowns
  - Add-ons cater for additional risk when collateral is similar to assets with prescribed haircuts but differs in specific features.
  - Example: Eurosystem applies a haircut add-on for assets issued in non-euro currencies and valuation markdowns to certain self retained covered bond securities to cater for possible double-default risk.

### Due diligence requirements
- For loan collateral, underlying data are generally not available and CBs rely on counterparties for provision. Counterparties may “self certify” variables; CBs should carry out checks to mitigate conflicts of interest.
- Ex ante
  - When potential need for LOLR is flagged in advance, operational and legal areas should perform on-site one-off ex ante verification checks to ensure data are correctly flagged on the counterparty’s system and to avoid cross collateralization or incorrect data sources.
- Ex post
  - CBs should ensure loans provided comply with minimum eligibility criteria prescribed. Conduct a series of checks/validations on pools provided:
    - Cross check sample loans against data on the counterparty’s systems; original documentation may need examination.
    - Bank legal teams should assess legal documentation of samples to ensure completeness and that underlying security exists.
  - In urgent idiosyncratic requests, ex ante checks can be completed ex post but within a short timeframe.
  - In some jurisdictions due diligence checks may not be necessary given regulatory regimes emphasizing bank self-discipline and market discipline.

*Source: IMF Staff.*

### APPENDIX IV. MINIMIZING STIGMA—THE CASE OF OPEN MARKET OPERATIONS

### APPENDIX IV. MINIMIZING STIGMA—THE CASE OF OPEN MARKET OPERATIONS

### Rationale for using OMOs to reduce stigma
- Stigma concerns could potentially be reduced, where a number of banks are stressed, by providing liquidity via an OMO. 130
- This could involve expanding the collateral accepted in the monetary policy framework and satisfy the liquidity need through—in some instances longer term—OMOs, and using an interest rate higher than the policy target. 131
- Difference from Goodfriend and King (1998) view: the CB does not rely on liquidity being distributed to ‘concerned’ banks; instead the required reserves provided will be bid for (only) by the institution(s) in need.
- Public announcement of such operations could help with market confidence.

### Operational design and collateral considerations
- Provision of (possibly longer term) OMOs against collateral that is normally reserved for standing facilities (if there is a separate collateral list) could mitigate internal stigma constraints. 134
- Depending on the nature of demand, liquid securities instead of reserves could be provided. 131
- In many countries, even if counterparties have suitable monetary policy eligible collateral, there is at least an internal stigma associated with accessing standing facilities, as the performance of bank treasurers is sometimes measured on their usage of these facilities. 133
- Example precedent: in the U.S. Federal Reserve’s TAF operation, longer term liquidity was made available to a wider set of counterparties against a wider list of collateral normally reserved for the overnight discount window. 134

### Experience from the Global Financial Crisis and central bank practices
- Similar approaches (sometimes pre-emptive) were adopted during the GFC by the Reserve Bank of New Zealand, the Reserve Bank of Australia and, to a certain extent, the ECB. 132
- In the euro zone, collateral constraints continued to impact peripheral banks even after the ECB expanded its collateral base; through their LTROs, the ECB relied to an extent on counterparties distributing LTRO reserves to concerned counterparties, which did not happen in practice. 132
- The use of OMOs to meet market-wide needs during the GFC helped to reduce stigma over accessing CB liquidity.
- Announcing clear eligibility criteria and intended goals of the systemic operations, disclosure of access only with an appropriate time lag, and the non-applicability of increased supervisory intrusion and conditionality, provided the banking system with more comfort in terms of access.

### Risks, stigma dynamics, and moral suasion
- Careful consideration needs to be given to the design of any market-wide operation; such solutions need constant innovation. (Paul Tucker in BIS (2014))
- Risk: if it is suspected these facilities assist illiquid institutions, “sound” institutions may publicly declare their intention not to use these facilities in the future.
- In the euro zone, some “stronger” banks publicly declared they had repaid their three-year LTRO borrowings, implying it was only ‘stressed’ institutions that remained in these operations.
- Any perceived stigma could potentially be managed through the use of moral suasion by the central bank, as was used recently by the BOE. 135
- Trade-off noted: removing stigma from liquidity provided via OMO must increase the risk of stigma for bilateral LOLR.

### Design principles and practical guidance (implicit recommendations)
- Central banks should have clear principles behind when they will provide such liquidity support and should not change these principles as individual liquidity needs arise. 130
- Eligibility criteria and intended goals of systemic OMOs should be announced clearly to reduce stigma and provide system-wide comfort.
- Disclosure of access should be managed with an appropriate time lag to protect counterparties from stigma.
- The non-applicability of increased supervisory intrusion and conditionality for market-wide OMOs should be explicit to encourage participation.
- Moral suasion can be a tool to mitigate perceptions that only stressed institutions use the facility; evidence of successful use includes BoE engagement with larger U.K. banks. 135

*Source: APPENDIX IV. MINIMIZING STIGMA—THE CASE OF OPEN MARKET OPERATIONS*

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