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Central Bank's Lending to Troubled Commercial Banks

Discuss whether a central bank should lend to commercial banks which get into financial difficulties.

Category:

Macroeconomic Factors and Policies

Frequently asked question

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Answer

Use headers or subheadings to break down your essay into manageable sections.

➡Title: Should a Central Bank Lend to Commercial Banks in Financial Difficulties?
🍃Introduction: The role of a central bank in the financial system is crucial, particularly in times of economic distress. One of the key functions of a central bank is acting as a lender of last resort, providing liquidity support to commercial banks facing financial difficulties. However, the decision to lend to struggling banks is not without controversy. This essay will critically evaluate both sides of the argument, examining the reasons for and against a central bank lending to commercial banks in financial distress.
I. Reasons for a Central Bank to Lend to Commercial Banks
➡️1. Lender of Last Resort Function: A central bank plays a vital role in maintaining financial stability by acting as a lender of last resort -. By providing emergency liquidity assistance to commercial banks that cannot access funding from other sources, the central bank can help prevent bank failures and systemic crises -. This function is crucial in maintaining public confidence in the banking system and preventing contagious runs on other banks -.
➡️2. Mitigating Negative Economic Impact: Allowing commercial banks to collapse without lending support can have severe repercussions on the economy -. Bank failures can lead to depositors losing their funds, causing a loss of confidence in the banking system -. This loss of confidence may trigger panic withdrawals from other banks, destabilizing the entire financial system -. By lending to troubled banks, the central bank helps mitigate the negative economic impact of bank failures, preserving stability and promoting economic growth -.
➡️3. Ensuring Availability of Credit: A healthy banking sector is essential for providing credit to businesses and households -. If struggling banks are not provided with liquidity support, they may curtail lending activities, reducing the availability of credit for productive investments -. By lending to commercial banks in financial difficulties, the central bank helps maintain the flow of credit in the economy, supporting investment and economic growth -.
II. Reasons against a Central Bank Lending to Commercial Banks
➡️1. Moral Hazard: Lending to troubled banks can create moral hazard -. If banks believe they can rely on the central bank for liquidity support, they may be incentivized to take excessive risks, assuming that they are "too big to fail" -. This moral hazard problem can undermine market discipline and lead to a misallocation of resources -. Critics argue that it is important for banks to bear the consequences of their own risk-taking rather than relying on central bank intervention.
➡️2. Opportunity Cost: Providing loans to troubled banks comes with an opportunity cost for the central bank -. The funds used for lending could be alternatively deployed to support new, expanding banks or other sectors of the economy -. This raises questions about the allocation of resources and the potential trade-offs between supporting struggling banks and fostering overall economic growth -.
👉Conclusion: The decision of whether a central bank should lend to commercial banks in financial difficulties is a complex one, involving considerations of financial stability, economic growth, and moral hazard. While providing liquidity support can help prevent banking crises, maintain public confidence, and support economic activity, it also raises concerns about moral hazard and opportunity costs. Striking a balance between safeguarding financial stability and ensuring accountability within the banking sector is crucial. Central banks must carefully evaluate the circumstances, exercise prudential judgment, and implement appropriate safeguards to mitigate moral hazard risks. Ultimately, the central bank's primary objective should be to maintain the stability and resilience of the financial system while minimizing adverse consequences for the broader economy.

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I. 🍃Introduction
- Explanation of the topic
- Brief overview of the arguments for and against central banks being lenders of last resort

II. Arguments for central banks being lenders of last resort (up to ➡️5 marks)
- Function of a central bank as a lender of last resort
- Importance of lending to commercial banks to prevent collapse
- Potential consequences of not lending (loss of money, bank runs, reduced investment, economic decline)
- Importance of commercial banks carrying out their function

III. Arguments against central banks being lenders of last resort (up to ➡️5 marks)
- Potential encouragement of risky behavior by banks
- Perception of being "too big to fail"
- Opportunity cost of using funds for lending to established banks instead of new, expanding ones

IV. 👉Conclusion
- Summary of arguments for and against central banks being lenders of last resort
- Personal opinion on the matter

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Up to ➡️5 marks for why it should: A central bank is a lender of last resort - one of its functions is to lend to commercial banks when they cannot borrow elsewhere - example of another function -. If a central bank does not lend, the commercial banks may collapse - holders of bank accounts will lose money - they may get into difficulties - there may be a ‘run’ on other banks - with people withdrawing their money - putting other banks at risk -. Fewer banks would reduce the funds for firms to borrow - investment would be reduced - economic growth would decline - makes it more difficult for commercial banks to carry out their function - example of another function -.
Up to ➡️5 marks for why it should not: May encourage banks to take risks - lend to creditworthy customers - they may think they are too big to fail -. It would involve an opportunity cost - could use funds to lend to new, expanding banks -.

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