CHAPTER 4

Coping with Crises: Policies, Institutions, and Markets

The case of Lehman Brothers strikingly illustrates the dilemma authorities may face in dealing with a liquidity squeeze of a systemically important financial institution. In that event, policy makers decided not to provide liquidity support, letting market discipline punish Lehman Brothers, triggering a crisis of confidence and the financial intermediation's collapse that ensued. History and numerous analyses will judge the role of that decision. For our purpose, the case illustrates public financial authorities' challenges, namely: (1) to be able to judge whether a liquidity shortage in a financial institution is merely a short-term liquidity problem or a deeper solvency issue; (2) to be able to judge the impact on the rest of the financial system of a decision to provide or not liquidity to a financial institution facing a shortage; (3) to have available financial instruments to provide liquidity without distorting markets, if the authorities decide to do so; and (4) to have in place mechanisms to resolve in an orderly fashion not only single but even more importantly a series of distressed financial institutions.

The chapter first reviews monetary and systemic liquidity management policies that essentially aim at containing crises and limiting their spread. Core issues are the Shari'a compliance of policy instruments targeting liquidity management, and their insertion in a policy framework that can apply to ...

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