This paper addresses the issue of the optimal behaviour of the Lender of Last Resort (LOLR) in its microeconomic role regarding individual financial institutions in distress. It has been argued that the LOLR should not intervene at the microeconomic level and let any defaulting institution face the market discipline, as it will be confronted with the consequences of the risks it has taken. By considering a simple cost benefit analysis we show that this position may lack a sufficient foundation. We establish that, instead, under reasonable assumptions, the optimal policy has to be conditional on the amount of uninsured debt issued by the defaulting bank.Yet in equilibrium, because the rescue policy is costly, the LOLR will not rescue all the banks that fulfill the uninsured debt requirement condition, but will follow a mixed strategy. This we interpret as the confirmation of the 'creative ambiguity' principle, perfectly in line with the central bankers claim that it is efficient for them to have discretion in lending to individual institutions. Alternatively, in other cases, when the social cost of a bank's bankruptcy is too high, it is optimal for the LOLR to bail out the institution, and this gives support to the 'too big to fail' policy.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Publisher Info
Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
2238.
Find related papers by JEL classification: E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data) G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)