Modern central banks were & are justified on the grounds that they provide a means to insure economic stability by supporting “sound” money & “sound” banking practices. However, there is considerable reason to believe that central banks create “moral hazards” that undermine both “sound” money & “sound” banking.
Walter Bagehot specified the role of central banks as lender-of-last-resort in response to a liquidity crisis. According to him, they should lend “freely”, but temporarily, against sound collateral & at penalty rates. It is clear that Bagehot did not think much of the argument in insisting on such stringent limits.
But modern central banks do not take Bagehot’s case to heart. His idea of setting a penalty rate was to provide a motivation for commercial banks to pay off emergency loans once financial markets returned to normal conditions. However, central banks tend to provide liquidity at subsidized rates for periods without imposing strict limits on the duration of the loans.
In all events, the role of lend-of-last-resort seems to be made necessary when central banks hold most of the reserves of the banking system so there are few other sources of liquidity.
Concentrating reserves in one place creates a moral hazard that undermines the presumed benefits of central bank interventions to offset liquidity problems so that the banking system will be less stable. As banks scramble for liquidity after a credit crunch, they will all seek funds from a common pool of reserves that can cause the money supply to contract.
As central bankers offer relaxed collateral requirements and lend at subsidized interest rates, insolvent institutions divert resources from solvent ones. As solvent banks will be unable to lend, credit and overall economic activity will be stifled.
At the same time, deposit insurance that replaced the doctrine of “double liability” previously imposed on bank owner-shareholders undermined sound banking practices.
From the end of the Civil War to the Great Depression, stockholders of nationally-chartered banks had to place more capital if the institution was impaired or insolvent. As such, shareholder-owners of US commercial banks were held responsible both for its safety and soundness.
This “doctrine of double liability” meant that they were responsible for a portion of bank debts after insolvency, an amount up to and including the par value of their stock. Despite being contrary to the “limited liability” notion of conventional corporations, the US Supreme Court, lower federal courts and state courts upheld this arrangement.
Double liability meant that if investors engaged in risky activities for their own advantage would bear the burden if the increased risks led to losses. Since many small banks are closely held while most larger banks tend to be controlled by a bank holding company, shareholders will be more likely to be successful in controlling the risk-taking tendencies of banks.
Supporters of deposit insurance insisted that it provided better arrangements for covering risks of losses, while ignoring “moral hazard” issues arising from it as well as the loss of the beneficial effects of the “doctrine of double liability”.