Cleveland Fed researcher says in liquidity crises central banks must lend directly to banks that will be solvent once market conditions have returned to normal

A researcher at the Cleveland Fed, Filippo Occhino, shows in a recent study that the appropriate response of the central bank to a liquidity crisis is to lend directly to banks. Occhino explains how banks can appear to be insolvent during a crisis even though they would be sound under normal economic conditions. Occhino finds that to keep a liquidity crisis from turning into a costly, full-fledged economic crisis, central banks must lend directly to banks that would be solvent under normal economic conditions, at lending terms that are consistent with normal market conditions.

Occhino notes two other key findings of his study:

• Information gathered by bank supervisors before the crisis can be useful in helping the central bank assess whether a bank would be solvent under normal market conditions.
• Some rules and regulations may restrict the ability of the central bank to lend to banks that appear insolvent in the midst of the crisis, at lending terms that do not reflect crisis market conditions. When setting such restrictions, it is important to consider the risk that the central bank may not be able to effectively stop a liquidity crisis from turning into a larger economic crisis.

Read Central Bank Lending in a Liquidity Crisis

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892