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Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage

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  • 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. The 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. Several 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.

Suggested Citation

  • Viral V. Acharya & Bruce Tuckman, 2013. "Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage," NBER Working Papers 19773, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19773
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    Cited by:

    1. Weber, Patrick, 2015. "Does the Eurosystem's lender of last resort facility has a structurally di fferent option value across banks?," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 113123, Verein für Socialpolitik / German Economic Association.
    2. Acharya, Viral & Pierret, Diane & Steffen, Sascha, 2016. "Lender of last resort versus buyer of last resort: The impact of the European Central Bank actions on the bank-sovereign nexus," ZEW Discussion Papers 16-019, ZEW - Leibniz Centre for European Economic Research.
    3. Acharya, Viral V. & Fleming, Michael J. & Hrung, Warren B. & Sarkar, Asani, 2017. "Dealer financial conditions and lender-of-last-resort facilities," Journal of Financial Economics, Elsevier, vol. 123(1), pages 81-107.
    4. Céline Gauthier & Alfred Lehar & Héctor Pérez Saiz & Moez Souissi, 2015. "Emergency Liquidity Facilities, Signalling and Funding Costs," Staff Working Papers 15-44, Bank of Canada.
    5. F. Koulischer, 2015. "Asymmetric shocks in a currency union: The role of central bank collateral policy," Working papers 554, Banque de France.
    6. Pierluigi Morelli & Giovanni Pittaluga & Elena Seghezza, 2015. "The role of the Federal Reserve as an international lender of last resort during the 2007–2008 financial crisis," International Economics and Economic Policy, Springer, vol. 12(1), pages 93-106, March.
    7. Garcia-de-Andoain, Carlos & Heider, Florian & Hoerova, Marie & Manganelli, Simone, 2016. "Lending-of-last-resort is as lending-of-last-resort does: Central bank liquidity provision and interbank market functioning in the euro area," Journal of Financial Intermediation, Elsevier, vol. 28(C), pages 32-47.
    8. Aitor Erce, 2015. "Bank and sovereign risk feedback loops," Globalization Institute Working Papers 227, Federal Reserve Bank of Dallas.
    9. , 2016. "Funding Illiquidity," Working Papers on Finance 1601, University of St. Gallen, School of Finance, revised Sep 2019.

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    More about this item

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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