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The Lender of Last Resort: A Twenty-First Century Approach

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  • Xavier Freixas

    (Universitat Pompeu Fabra,)

  • Jean-Charles Rochet

    (University of Toulouse, IDEI, and Toulouse Business School,)

  • Bruno M. Parigi

    (University of Padova,)

Abstract

The classical Bagehot conception of a Lender of Last Resort (LOLR) that lends to illiquid banks has been criticized on two grounds: On the one hand, the distinction between insolvency and illiquidity is not clear-cut; on the other, a fully collateralized repo market allows central banks to provide the adequate aggregate amount of liquidity and leave to the banks the responsibility of lending uncollateralized. The object of this paper is to analyze these issues rigorously by providing a framework in which liquidity shocks cannot be distinguished from solvency ones and then asking whether there is a need for a LOLR and how it should operate in the absence of systemic threats. Determining the optimal LOLR policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our setup, the results depend upon the existence of moral hazard. If the main source of moral hazard is the banks' lack of incentives to screen loans, then the LOLR may have to intervene to improve the efficiency of an unsecured interbank market in crisis periods; if instead the main source of moral hazard is loan monitoring, then the interbank market should be secured and the LOLR should never intervene. (JEL: E58, 628) Copyright (c) 2004 by the European Economic Association.

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Bibliographic Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 2 (2004)
Issue (Month): 6 (December)
Pages: 1085-1115

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Handle: RePEc:tpr:jeurec:v:2:y:2004:i:6:p:1085-1115

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Cited by:
  1. James T. E. Chapman & Antoine Martin, 2007. "Rediscounting under aggregate risk with moral hazard," Staff Reports 296, Federal Reserve Bank of New York.
  2. Ewerhart, C. & Valla, N., 2008. "Financial market liquidity and the lender of last resort," Financial Stability Review, Banque de France, issue 11, pages 133-148, February.
  3. Niinimäki, J.-P., 2009. "Does collateral fuel moral hazard in banking?," Journal of Banking & Finance, Elsevier, vol. 33(3), pages 514-521, March.
  4. Ratnovski, Lev, 2013. "Liquidity and transparency in bank risk management," Journal of Financial Intermediation, Elsevier, vol. 22(3), pages 422-439.
  5. Niinimaki, J.-P., 2012. "Hidden loan losses, moral hazard and financial crises," Journal of Financial Stability, Elsevier, vol. 8(1), pages 1-14.
  6. Skeie, David R., 2008. "Banking with nominal deposits and inside money," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 562-584, October.
  7. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.

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