Systemic risk, moral hazard and the lender of last resort

Overview

Systemic risk, bank run and contagion in a financial system.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is systemic risk?

   Model answer

   Systemic risk is the danger that the failure of one institution brings down the whole financial system. Banks are connected through lending and payment obligations to each other.

2. 2

   Why are banks especially vulnerable to a loss of confidence?

   Model answer

   Banks lend out most of the deposits they take in. A bank cannot repay all its depositors at once if they demand their money.

3. 3

   What is a bank run?

   Model answer

   A bank run occurs when depositors withdraw their money together for fear of losing it. The withdrawal itself can make an otherwise sound bank insolvent.

4. 4

   What is contagion in a financial system?

   Model answer

   Contagion is the spread of distress from one institution or market to others. Losses at one bank lead lenders to withdraw funding from similar banks.

5. 5

   What does lender of last resort mean?

   Model answer

   The lender of last resort is the central bank role of lending to banks that cannot borrow elsewhere. Emergency lending stops a shortage of cash becoming a collapse.

6. 6

   State the classic rule for lending of last resort.

   Model answer

   The classic rule is to lend freely, at a penalty rate, against good collateral. Walter Bagehot set out the rule in the nineteenth century.

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