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The lender of last resort: liquidity provision versus the possibility of bail-out

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  • Eijffinger, Sylvester C. W.
  • Nijskens, Rob

Abstract

Banking regulation has proven to be inadequate to guard systemic stability in the recent financial crisis. Central banks have provided liquidity and ministries of finance have set up rescue programmes to restore confidence and stability. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and takes excessive risk compared to the social optimum. A Lender of Last Resort can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce a fiscal authority that is able to bail out the bank by injecting capital. This authority faces a trade-off: when it imposes strict bailout conditions, investment increases but moral hazard ensues. Milder bailout conditions reduce excessive risk taking at the expense of investment. This resembles the current situation on financial markets, in which banks take less risk but also provide less credit to the economy.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7674.

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Date of creation: Feb 2010
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Handle: RePEc:cpr:ceprdp:7674

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Keywords: Bailout; Bank Regulation; Capital; Lender of Last Resort; Liquidity;

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  1. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  2. Charles A. E. Goodhart & Haizhou Huang, 1999. "A model of the lender of last resort," Proceedings, Federal Reserve Bank of San Francisco.
  3. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
  4. Charles M. Kahn & João A. C. Santos, 2001. "Allocating bank regulatory powers: lender of last resort, deposit insurance and supervision," BIS Working Papers 102, Bank for International Settlements.
  5. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  6. Rochet, Jean Charles & Vives, Xavier, 2002. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," CEPR Discussion Papers 3233, C.E.P.R. Discussion Papers.
  7. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110, September.
  8. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
  9. Xavier Freixas & Bruno M. Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, pages 611-640.
  10. Eduardo Levy Yeyati & Tito Cordella, 1999. "Bank Bailouts," IMF Working Papers 99/106, International Monetary Fund.
  11. Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
  12. Repullo, Rafael, 2005. "Liquidity, Risk Taking, and the Lender of Last Resort," MPRA Paper 826, University Library of Munich, Germany.
  13. Viral Acharya & Tanju Yorulmazer, 2007. "Cash-in-the-market pricing and optimal resolution of bank failures," Bank of England working papers 328, Bank of England.
  14. Bagehot, Walter, 1873. "Lombard Street: A Description of the Money Market," History of Economic Thought Books, McMaster University Archive for the History of Economic Thought, number bagehot1873.
  15. Allen, Franklin & Carletti, Elena & Gale, Douglas, 2009. "Interbank market liquidity and central bank intervention," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 639-652, July.
  16. Nijskens, Rob & Wagner, Wolf, 2011. "Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1391-1398, June.
  17. Bank for International Settlements, 2009. "An assessment of financial sector rescue programmes," BIS Papers, Bank for International Settlements, number 48, May.
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