Limited commitment and central bank lending
AbstractCentral bank or International Monetary Fund lending should be regarded as a line of credit, analogous to private line-of-credit products. Contractual provisions in private line-of-credit arrangements are designed to control managerial moral hazard and provide a means for profit-maximizing lenders to credibly commit to withdraw credit and induce closure when appropriate. The contractual mechanisms utilized by private line-of-credit providers are not effective for a central bank whose primary missionâto maintain financial system stabilityâcan override its obligation to protect public funds and undercut its ability to limit its lending reach. We consider in some detail five broad approaches to a central bankâs commitment problem: good offices only, collateralization and early intervention, constructive ambiguity, extending supervisory and regulatory reach, and reputation building. Our analysis suggests that the first four institutional approaches cannot be counted on to overcome the fundamental forces inducing a central bank to lend. We argue that the only practical way for a central bank to credibly limit lending is for it to build up over time a reputation for restraint.
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Bibliographic InfoArticle provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.
Volume (Year): (1999)
Issue (Month): Fall ()
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