Viral Acharya and Bruce Tuckman write on the moral hazard of lender of last resort facilities and the adverse consequences they are likely to have on financial stability, and propose a variety of remedies. It’s high time this issue was carefully addressed by academics, so I’m very pleased to see this paper.
I do have one quibble with the paper, however. It presents the lender of last resort as designed to support banks through crises by supporting the value of long-term, illiquid assets. I think the constraints of the theory here are undermining our discussion of what a lender of last resort should do. Bagehot’s lender of last resort lent mostly against 3 month paper — it might have been possible for one-year paper to be discounted by the lender of last resort in 19th c. Britain, but lending against “long-term” assets was unthinkable at the time.
In my view, models should evaluate short-term, medium-term and long-term assets. And it is open to question whether the lender of last resort should be providing any support to assets that are truly long-term — that is, in excess of three or five years — with the exception of Treasuries. After all it’s from clear that financial intermediaries should be carrying long-term assets (other than Treasuries) on their balance sheets at all, except in the trading book — which should be managed so that the banks don’t need access to a lender of last resort under any circumstances.
This view is a very different model of the financial system than the one we have, but I’m not sure there’s any way to stabilize the one we have for the reasons presented in Acharya and Tuckman together with the fact that the longer one goes, the harder it is to establish the value of any asset.