With the recent mayhem caused by financial crisis, it is clear how some of the financial system’s liquidity risk can lead to the insolvency of the whole financial segment, such as the unsecured interbank markets that contributed to liquidity issues (Norris, 2009). Hence, to govern the liquidity issue, central banks come into place by acting as an intermediary for interbank transaction and at the same time preventing the market’s financial system from collapsing altogether (Carrel, Paul et al., 2011). Therefore, this research paper is drawn to first address the issues of moral hazard during lending of last resort, then on the possible policy solutions to counter the liquidity and insolvency problems of ‘too-big-to-fail’ crisis in the financial market.
Moral hazard in terms of financial system refers to a situation where an institution is being shield from risk, which then changes its behavior as compared to how it would react during situation where there is lack of security (Turner, 2009); it can also be known as the term Lender of Last Resort (LOLR). LOLR’s core function is to emphasize on crafting a situation to counter the intended avoidance of a condition. In Layman’s term, LOLR act as a safety net for financial institutions when hazard or risk occurs (Eichengreen, 2010). By taking note on the importance of moral hazard, governments had agreed on the introduction of LOLR, because loss of confidence will arise when financial distress happens in a financial segment. Besides, without any back-up system, the collapse of the financial situation will worsen (Schwarcz, 2009).
According to Knedlik, (2010), the recent event of financial distress had lead to loss in confidence in governmental and central backing support, which will obstruct the growth and investment of the financial market in the long run. Also, generally, private financial institutions often are unable to solve their distressing situation, which needs the central bank’s intervention or LOLR backing (Vollmer, 2009). In short, moral hazard is a fundamental situation that will occur in the lending and borrowing action and its ideology had been convoluted based on two factors to today global economic system.
First is the blur line between liquidity and insolvency. Generally, when a financial institution is accepting monetary aid from LOLR, is regarded as facing a liquidity predicament. As shown in the 2008-09 financial meltdown, banks faced financial distress because the long-term assets cannot cover the short-term liabilities within their financial system. Such conditions are bound to happen because, acquiring short term liabilities and long term assets will first make the financial institution liquid then insolvent at a point of time, and as a result, pushes the financial institution to be involve with bad investment of assets, hence causing the institution to face further liquidity risk (Holmstrom & Tirole, 2011).
Secondly will be the global financial system that places pressure on few large institutions, motivating them to be so large that once there is financial distress, would endanger the whole financial system altogether, hence the term ‘too-big-to-fail’. When such large financial institutions are facing insolvency, LOLR might not be able to bail them out due to the rising amount, thus leading to the collapsed of the institution like the financial breakdown of Lehman Brothers during 2008 (Gros, & Thomas, 2010).
Therefore, taking into notice that the moral hazard evolving around the ‘too-big-to-fail’ financial institutions and the blur distinction of liquidity and insolvency issue resolutions should be address. This is when Walter Bagehot’s theory comes into place. According to Eichengreen (2010), as suggested by Walter Bagenhot himself, a lender of the last resort should lend, as it will ease the unfavorable impact of a liquidity crisis, which then allows stability of banking system and minimization of adverse impact on the real market.