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Balancing LOLR Assistance with Avoidance of Moral Hazard By C.A.E. Goodhart Financial Markets Group London School of Economics 1 • If an agent is absolutely 100% sure to repay all debts as promised, it can always issue its own IOU. • Specific paper money, the concept of liquidity, and the need for banks, all derive from the fact that default can never be ruled out completely. • So a liquidity need almost always, absent physical problems, implies an underlying solvency concern. 2 • Solvency is a slippery concept. Based on what valuations? Not independent of the Central Bank’s own actions. • Problem coming with Bail-In. • Bagehot rule on lending on good collateral compromised by stigma concerns. 3 • Lend to the market, not to the individual institution, (Dodd-Frank Act). • An incorrect assessment of contagion. 4 But Moral Hazard • Treat first worst. • Involve other banks, (life-raft). • Change the Incentive Structure o get rid of limited liability for insiders o pay bonuses in bail-inable debt 5 • Collective error much more responsible for crises than cyclical risk shifting. • Even so, the imposition of penalties for failure will benefit the political context. 6