The ECB released a document discussing moral hazard and its role as the lender of last resort to banks facing a liquidity crisis.  In the document, the ECB made the case for the circumstances under which it wouldn’t fulfill one of its primary reasons for existence and act as a lender of last resort.  Specifically, the ECB wouldn’t act as a lender of last resort if this

could increase the risk of moral hazard on the side of financial institutions or responsible authorities.

The ECB justified this position by paraphrasing Walter Bagehot’s prescription for when a central bank should fulfill its lender of last resort role.

The objective of ELA [emergency liquidity assistance] is to support solvent credit institutions facing temporary liquidity problems.

In Transparency Games, I discuss how the introduction of deposit insurance changed Bagehot’s prescription.  When Bagehot offered his assessment, deposit insurance didn’t exist.  As a result, the only was a central bank knew it could be repaid was if it lent to a solvent bank.  Deposit insurance changed this as it effectively made the taxpayers an insolvent bank’s silent equity partner.  As a result, a central bank knows it will be repaid as the taxpayers will repay it if the bank is unable to.

This point bears repeating.  With deposit insurance, central banks are protected from loss not just from the collateral they receive for making a loan as a lender of last resort, but also by the taxpayer of the country hosting the bank.

Given the taxpayer ultimately stands behind the lender of last resort loans, central banks should automatically extend these loans in any amount necessary if the country with the banks facing a liquidity crisis requests it.

The ECB is right there is a moral hazard related to its lender of last resort role.  The moral hazard is the ECB believes it has and other central banks have discretion in acting as a lender of last resort.  This discretion creates the moral hazard central banks will act as a political player.

Eliminating this moral hazard is straightforward.  Central banks should be given no discretion when it comes to acting as a lender of last resort.