The theory of Lender of Last Resort (LLR) is originally dated back to the British banking system around year 1900. The function of a LLR is to prevent financial crises by problems in individual financial institutions or markets. The LLR lend freely in times of crisis, at a penalty rate, on the basis of collateral that is marketable in the ordinary course of business when there is no panic. The intervention of LLR to offer unlimited liquidity to financial institutions induces moral hazard by encouraging financial institutions to alter their behavior in a way that transfer the risk to the LLR. Moral hazard, because of intervention of the LLR, can be difficult to measure because of the costs of any intervention is delayed, thus more likely not to be associated with earlier actions of a LLR. The European Central Bank (ECB) works with other international institution to maintain financial stability. However in the euro area ECB acts as a central bank and crisis lender, which makes ECB the LLR for the financial institutions in the euro area. The uncertainty and instability in the financial market have been very high in the period from mid-2007 to mid-2009, especially in October 2008 compared to the previous past five years. In the euro area this has led to the intervention from ECB as the LLR. During the financial turmoil and the crisis since 2007, ECB has acted as the LLR to ensure stability for financial institutions in the euro area; by offering unlimited liquidity through market operations and cutting the refinancing rate several times. To determine the risk behavior and moral hazard under such circumstances, behaviors are explained with utility functions, where investors optimize their utility depending on their risk preferences. Loans within financial institutions are regarded as their main investments. The risk profile in financial institutions depends on the economic cycle, where investors tend to be more risk seeking in times of expansion and boom and more risk averse in times of economic contraction and recession. From analyzing loans, leverage and solvency in financial institutions it is possible to evaluate their risk behavior. There was a decline in risk aversion and increased risks in financial institutions until 2008. Hereafter the findings indicate increased risk aversion, but simultaneously ECB as the LLR minimizes this increase. Without the present of ECB as a LLR, the financial institutions in the euro area are expected to reduce their risk exposure further. In the future the awareness of the presence of the ECB as a LLR and their willingness to provide the entire financial market with unlimited liquidity is probably to influence the financial institutions to be even more risk seeking in the next period of economic expansion and boom.
|Educations||MSc in Finance and Accounting, (Graduate Programme) Final Thesis|
|Number of pages||103|