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Liquidity, Risk Taking, and the Lender of Last Resort

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  • Rafael Repullo

    (CEMFI and CEPR)

Abstract

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 1 (2005)
Issue (Month): 2 (September)
Pages:

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Handle: RePEc:ijc:ijcjou:y:2005:q:3:a:2

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References

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  1. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Center for Development Economics 2008-09, Department of Economics, Williams College.
  2. Douglas W. Diamond & Raghuram G. Rajan, 1999. "A Theory of Bank Capital," NBER Working Papers 7431, National Bureau of Economic Research, Inc.
  3. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
  4. Jean-Charles Rochet & Xavier Vives, 2002. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," FMG Discussion Papers dp408, Financial Markets Group.
  5. Repullo, Rafael, 2004. "Capital requirements, market power, and risk-taking in banking," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 156-182, April.
  6. Cordella, Tito & Yeyati, Eduardo Levy, 2003. "Bank bailouts: moral hazard vs. value effect," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 300-330, October.
  7. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
  8. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer, vol. 18(1), pages 63-84, October.
  9. Prat, Andrea, 2003. "The Wrong Kind of Transparency," CEPR Discussion Papers 3859, C.E.P.R. Discussion Papers.
  10. Charles M. Kahn & João A.C. Santos, 2001. "Allocating bank regulatory powers: lender of last resort, deposit insurance, and supervision," Proceedings 717, Federal Reserve Bank of Chicago.
  11. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
  12. Repullo, Rafael, 2004. "Policies for Banking Crises: A Theoretical Framework," CEPR Discussion Papers 4727, C.E.P.R. Discussion Papers.
  13. Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
  14. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  15. Goodfriend, M. & King, R.G., 1988. "Financial Deregulation, Monetary Policy, And Central Banking," RCER Working Papers 121, University of Rochester - Center for Economic Research (RCER).
  16. Marvin Goodfriend & Jeffrey M. Lacker, 1999. "Limited commitment and central bank lending," Working Paper 99-02, Federal Reserve Bank of Richmond.
  17. Flannery, Mark J, 1996. "Financial Crises, Payment System Problems, and Discount Window Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 804-24, November.
  18. Martin Gonzalez Eiras, 2003. "Bank's Liquidity Demand in the Presence of a Lender of Last Resort," Working Papers 61, Universidad de San Andres, Departamento de Economia, revised Sep 2003.
  19. Benjamin A. Friedman & E. Gerald Corrigan & Irvine H. Sprague & Norman Strunk & Joseph A. Grundfest, 1991. "The Risks of Financial Crises," NBER Chapters, in: The Risk of Economic Crisis, pages 19-83 National Bureau of Economic Research, Inc.
  20. Patrick Bolton & Xavier Freixas, 2000. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 324-351, April.
  21. Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.
  22. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
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