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The Lender of Last Resort: Liquidity Provision Versus the Possibility of Bail-out

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  • Eijffinger, S.C.W.
  • Nijskens, R.G.M.

    (Tilburg University, Center for Economic Research)

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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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2010-20.

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Date of creation: 2010
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Handle: RePEc:dgr:kubcen:201020

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Web page: http://center.uvt.nl

Related research

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

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  1. Rochet, Jean-Charles & Vives, Xavier, 2004. "Coordination Failures and the Lender of Last Resort : Was Bagehot Right After All?," IDEI Working Papers 294, Institut d'Économie Industrielle (IDEI), Toulouse.
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  11. 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.
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  13. Eduardo Levy Yeyati & Tito Cordella, 1999. "Bank Bailouts," IMF Working Papers 99/106, International Monetary Fund.
  14. 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.
  15. Haizhou Huang & Charles Goodhart, 1999. "A Model of the Lender of Last Resort," FMG Discussion Papers dp313, Financial Markets Group.
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  17. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
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