Governments and central banks provide three broad types of funding or liquidity support to banks and it is important to distinguish between these in a review of the lender of last resort function. These are:
Ø the provision of intra-day or overnight liquidity to alleviate short-term cash flow shortages (e.g. payment system requirements);
Ø the lender of last resort is a source of liquidity support by the central bank which may be provided to banks in difficulties on a short-term basis and is usually only provided when there is a potential systemic risk; and
Ø equity or capital support may be provided to failed or insolvent institutions for reasons of public interest. This is usually a government decision.
In addition, central banks may also provide leadership in arranging rescue operations to help failed institutions (e.g. the Bank of England in the case of Barings and more recently, the Federal Reserve in the case of the Long-Term Capital Management hedge fund). This is again usually performed to reduce the risk of knock-on effects to the rest of the banking system.
The focus of this section is the role of lender of last resort, although it is noted that the HKMA also provides overnight liquidity through the operation of the discount window.
The official lender of last resort in Hong Kong is the HKMA. The means available for this purpose are provided by the Exchange Fund30, which the HKMA manages on behalf of the Financial Secretary. This was in fact the situation even prior to the establishment of the HKMA, where the Exchange Fund, in connection with the powers and duties of the Commissioner of Banking and the Financial Secretary, together formed the lender of last resort. However, with the advent of the HKMA, there is now more of an institutional focus to the lender of last resort function.
The HKMA has general discretion on whether to provide any assistance as the lender of last resort. However, some broad principles have been set out concerning the circumstances in which the HKMA may provide such assistance31. These are:
Ø Whether the failure of the individual bank would, either by itself or through the creation of a domino effect, damage the stability of the exchange rate or the monetary or financial systems.
Ø The assistance of the lender of last resort would only be provided after the bank has exhausted its own liquidity resources and commercial sources of finance.
30 Following the Exchange Fund (Amendment) Ordinance 1992, which provided for the establishment of the HKMA, it is now clear that the Exchange Fund can also be used to maintain the stability and integrity of the monetary and financial systems of Hong Kong, except where that would conflict with the primary purpose of maintaining exchange rate stability.
31 Source: HKMA Quarterly Bulletin April 1994
Ø The liquidity support is only provided to institutions which are solvent and then only on the basis of security and at rates which are commercial, if not penal.
The government has, in the past, exercised its discretion to organise rescues by soliciting assistance from other banks. Alternatively, it has taken over ailing banks (e.g.
Overseas Trust Bank and Hang Lung Bank in 1986) using resources from the Exchange Fund. In fact, in the consultation paper32 on deposit insurance in 1992, it was stated:
“In the case of Hong Kong, the government has made it clear that liquidity support for solvent banks would be forthcoming from the Exchange Fund but that there can be no assurance that an insolvent bank would necessarily be rescued. Each case would have to be considered on its merits in the light of the implications for the stability of the banking system as a whole.”
During the course of the most recent bank run in 1997, the Financial Secretary also announced that support from the Exchange Fund would be provided if necessary (although it was not required in that case).
1.7.2 Assessment of the lender of last resort
Although the HKMA has articulated its position regarding the role of lender of last resort, there is no official policy document setting this out. Additionally, there is still a substantial level of uncertainty in the market in this respect. There is a large number of participants in the sector who are either unaware that there is actually a lender of last resort or are unclear as to the conditions under which the HKMA would provide this assistance. This uncertainty may be associated with certain developments that have occurred in the past. In particular:
Ø The reasons behind the government’s decisions to act as the lender of last resort to provide assistance to certain institutions but not others (e.g. BCC HK33) and the basis on which the government organised rescues in conjunction with other banks, instead of using the resources of the Exchange Fund were not always made clear.
Ø Although the HKMA has assumed the role as lender of last resort, it has never actually exercised this role since its establishment in 1993.
Ø The resources available to the lender of last resort come from the Exchange Fund.
Although the HKMA manages the Exchange Fund, the general perception is unclear as to whether it is the HKMA or the government that actually has the role of lender of last resort. This was especially noticeable in the incident of a bank run in 1997, where it was the government (due to the fact it is the Financial Secretary who controls the Exchange Fund) that announced the support of the Exchange Fund.
32 The government consultation paper “Deposit Protection Scheme” – Monetary Affair Branch Government Secretariat February 1992.
33 This reflected the discretionary element as the BCC HK case was not regarded as systemic in nature.
1.7.3 Comparison with other international financial centres
The discussions on lender of last resort generally divide the approaches to this role into two different categories − convenience and necessity34. The European model has generally followed the convenience framework, which is characterised by the fact that the power to provide assistance is generally discretionary. In addition, these central banks all have measures in place to provide liquidity to the market, usually in conjunction with mechanisms associated with the issue and trading of government papers.
The US model (the necessity approach) on the other hand, follows a more rules-based approach in that liquidity support (on the security of sound assets) is only given to ensure that there is sufficient aggregate liquidity in the marketplace to mitigate systemic problems. In this case, particular banks may fail but that is of little concern as long as aggregate liquidity is maintained. Under this approach, the discount window forms an integral part of the lender of last resort. For example, the Federal Reserve provides three basic types of discount window credit as follows:
Ø adjustment credit (to help institutions meet short term liquidity needs);
Ø seasonal credit (to assist smaller institutions to manage liquidity needs that arise from regular seasonal swings in loans and deposits (e.g. agricultural banks)); and
Ø extended credit (which may be provided to institutions experiencing longer-term liquidity needs which result from exceptional circumstances).
The terms of access to extended credit are similar to the broad terms set out above for the HKMA to act as lender of last resort. That is, the borrower must:
Ø make full use of available alternative funds; and
Ø have plans in place to eliminate its liquidity problem (e.g. the Bank of New England used the discount window facility for several months but reduced its borrowings as it unwound transactions and sold assets).
It should be noted that with the introduction of the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) in 1991, there are now severe restrictions on depositories with weak capital conditions to access the Federal Reserve’s discount window. Additionally, since December 1993, the FDICIA has limited the availability of Federal Reserve credit for undercapitalised and critically undercapitalised institutions.
The FDICIA stipulates that the Federal Reserve may not lend to an undercapitalised institution for more than 60 days in any 120-day period without incurring a potential liability to the FDIC, unless the exceptions to this rule are met. The FDICIA also states that the Federal Reserve may not lend to a critically undercapitalised institution for more than five days beyond the date on which it became critically undercapitalised.
34 Source: Working Paper 8805 – “Lessons of the past and prospects for the future in lender of last resort theory” by Walker F.
Todd, Federal Reserve Bank of Cleveland
The basic discount rate (set by the Federal Reserve for monetary policy purposes) is applied to adjustment credits. Separate market related rates are applied for seasonal and extended credits. The rate for extended credits is always 50 basis points above the rates charged for seasonal credits for loans greater than 30 days.
1.7.4 Views of market participants
The lender of last resort was considered an important or essential element for a successful banking sector by 70% of the respondents to the banking sector survey.
However, the views obtained from banks on this issue showed that there was quite a high degree of misunderstanding among bankers on whether the HKMA is the lender of last resort and what this role involves.
A large number of institutions interviewed also held the perception that the Liquidity Adjustment Facility (now replaced by the discount window) was the means by which the HKMA would exercise its role as lender of last resort.
All those interviewed agreed that the lender of last resort should be the HKMA.
1.7.5 Future considerations
The model of lender of last resort used in Hong Kong is akin to the European model, in that there is a discretionary power available to the HKMA to provide this assistance.
The principal disadvantage of this discretionary approach, compared to a rules-based approach, is that advances for liquidity assistance and advances for solvency or capital support may become blurred, because the exercise of this power may not be transparent.
The market uncertainty in relation to the issue of lender of last resort calls for a clarification by the HKMA on its policy in this regard. For example, in the South China Morning Post on 9 September 1998:
“The HKMA’s seven point package included the replacement of the Liquidity Adjustment Facility with a discount window, effectively removing the HKMA as a lender of last resort”
Recommendations
In view of the recent introduction of a number of liquidity measures, including the discount window, and the market uncertainty concerning the role of lender of last resort, we consider that it would be appropriate for the HKMA to take steps to reassess and clarify its role in this regard. It would be appropriate for the HKMA to formalise its policy in this area and to explain this policy, especially to market participants.
1.8 Interest Rate Rules