In what ways might the lender of last resort role of a central bank create a moral hazard problem? Discuss using explicit arguments and examples.ID Number: 000000000Date of hand in: 27/04/10In the modern financial market, a single individual or companies are very hard to have enough assets to achieve the huge investment. Therefore the banking system becomes an important role in using the borrower’s money to do the investment. And the bank makes the whole financial system works more smoothly and efficiently (Mishkin, 2007). The asset source of funds for the bank usage is from the bank selling their liabilities to people. And the deposit is the major way to represent the form of how bank selling their liabilities.
Banking is one of the most risky businesses in the financial market. Their risks include the national risk, market risk, credit risk and so on. Due to the risk exist commonly; banks have three main rules which are profitability, liquidity and security. However, the economic crisis can bring a huge loss to the bank or even break them down. At this point, when the bank facing huge loss, the central bank can always help them overcome the most difficult time. And this reaction from central bank can cause reliability in the common bank, which is the moral hazard problem in financial market. This essay will outline in what ways the lender of last resort role of a central bank might create a moral hazard problem.
In general, the moral hazard problem is after some people known they have been insured in something, they are likely to behave less tension in reducing costs (Parker, 1982). For example, assume a person got a commercial insurance in his/her car from an insurance company. He/she knows that whatever the car is damaged the insurance will pay the fixing fee back to the person. Then, he/she will drive or park less carefully to minimizing damages. This is an example of moral hazard problem in the insurance area.
Moral hazard in the financial market is the risk lender cannot get the funds back from the borrower. The lender here is the common bank and the borrower here is people ask for mortgage. If the borrower has a loss in investments, they would not able pay the loan back to the bank (Mishkin, 2007). And the bank will face a huge loss. The central bank will come to help them that central banks lend money to the common bank or central bank can produce more money. In this point, it is like central bank giving insurance to the common bank. Then, the common bank put too much reliability on central bank. Therefore banks do not check every borrower carefully or even make the fake report in risk assessment since at last it can ask central bank for help. And that is the subprime mortgage, which caused the economic crisis all over the world.
During 2000 to 2003, America using monetary police to reduce the interest rate to encourage people has more mortgages. Too much mortgages caused the liquidity of money increased and the inflation in USA is high. After that, the central bank of America wants to use raising the interest rate to control the inflation. However, the high interest rate caused many people cannot afford the loan from common banks. At the same time, the real estate is in depression, the borrower cannot get the subprime mortgage anymore and they cannot clear the mortgage even by selling the estate. In addition, the subprime mortgage does not have very good credit record and many of them do not have a stable income. Due to the raising of interest rate, even the people able to clear mortgage earlier, choose to pay mortgage later. Because of that, there are few people pay mortgage on time, lots of common banks lost their money. Central banks will re-lend the money to common banks in order to avoid the bankrupt of banks. Therefore, the moral hazard problem becomes more and more serious. The economic crisis happened.#p#分页标题#e#
银行essay范文Relending policy comes from the central bank system; it can control monetary and stabilize financial market and it is a backup for common banks. However, recently, the relending policy has been more and more focus on saving common banks from bankrupt and most of them are not able to pay back to the central bank. Lots of money has been investing in the low profit project. The gainers with relending money are not only considering the relending policy is based on credit relationship. Very few funds have been recollected by central banks, the credit system is nearly broken down. Therefore, central bank cannot hold the rules in relending policy anymore. The relending policy has fallen in to a vicious circle. At the very beginning, relending policy is designed as saving some companies or banks from the edge of bankrupt. Then, it is abused commonly which is causing more and more organizations have lower aspiration to pay back to central bank. After that, the efficiency of relending policy decreased. At the end, lots of important financial organizations become insolvency which make central bank has to put more money in relending usage. In this vicious circle central bank becomes an unstable role for the whole financial market. And that is all caused by the moral hazard problem.
The lender of last resort role of central bank, which is the relending policy, was designed as a good in financial market. However, the moral hazard problem is a common problem in human ethical history. The methods can resist moral hazard problem happen is by constructing a precise rule of relending policy in central bank. Central bank should evaluate the borrower’s ability in repayment and also monitor the usage of money. And also, people in common banks should not just relay on central bank, they should do the asset assessment carefully and eliminate the number of subprime mortgage.
ReferencesHermione Parker, 1982, The Moral Hazard of Social Benefits, The Institute of Economic Affairs, LondonFrederic S. Mishkin, 2007, The Economics of Money, Banking, and Financial Markets [8th Edition], Pearson Addison Wesley, London