There is a somewhat cliched old diagram that shows what we’re supposed to do when a bank gets into trouble. There are some nervous questions about this these days, but I still think the essence holds:
Solvent but illiquid
When a bank gets into trouble, the first question to ask is: Is it insolvent or is it just illiquid? If it’s merely illiquidity, then central banks should provide temporary liquidity support to a fundamentally sound firm. This liquidity backstop has always been a crucial role through which governments make the concept of a bank possible. The moral hazard involved here is controlled by making this liquidity support extremely expensive, so that banks should think thrice before using it.
These days, countries generally separate out the function of monetary policy, which is placed at an independent central bank, from the function of financial regulation and supervision which is placed at a financial regulator. In this case, a proper interface between the two agencies is required. To some extent, liquidity support is about merely having a central bank window where good quality assets are repoable at a penal rate (and with haircuts reflecting collateral risk). To some extent, this requires the financial regulator to make a call on whether a bank is merely illiquid or insolvent.
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