Working Paper: NBER ID: w19773
Authors: Viral V. Acharya; Bruce Tuckman
Abstract: While the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets. \n\nThe behavior of U.S. broker-dealers during the crisis of 2007-2009 is consistent with the unintended consequence just described. In particular, given the Federal Reserve's LOLR facilities, broker-dealers could afford to try to wait out the crisis. While they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures. \n\nSeveral mechanisms that might address this unintended consequence of LOLR facili--ties are explored: condition LOLR access and terms on the financial health of borrowers; condition LOLR access and terms on asset sales and deleveraging; and, especially, in--stead of supporting troubled financial firms, open LOLR facilities to financially sound, potential buyers of illiquid assets.
Keywords: LOLR facilities; illiquid leverage; financial institutions; deleveraging; default risks
JEL Codes: D62; E58; G01; G21; G24; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Availability of LOLR facilities (E52) | Deleveraging behavior of banks (G21) |
| Deleveraging behavior of banks (G21) | Probability of default (G33) |
| Availability of LOLR facilities (E52) | Probability of default (G33) |
| Availability of LOLR facilities (E52) | Risk exposure of banks (G21) |
| Moral hazard effect (G52) | Probability of default (G33) |