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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

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

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Liquidity Shortages and Banking Crises," NBER Working Papers 8937, National Bureau of Economic Research, Inc.
  2. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  3. Repullo, Rafael, 2005. "Liquidity, Risk Taking, and the Lender of Last Resort," MPRA Paper 826, University Library of Munich, Germany.
  4. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110, September.
  5. Acharya, Viral V. & Yorulmazer, Tanju, 2007. "Too many to fail--An analysis of time-inconsistency in bank closure policies," Journal of Financial Intermediation, Elsevier, vol. 16(1), pages 1-31, January.
  6. Jean-Charles Rochet & Xavier Vives, 2004. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1116-1147, December.
  7. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  8. 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.
  9. X. Freixas & B. Parigi & J-C. Rochet, 2000. "Systemic Risk, Interbank Relations and Liquidity Provision by theCentral Bank," DNB Staff Reports (discontinued) 47, Netherlands Central Bank.
  10. 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.
  11. Eduardo Levy Yeyati & Tito Cordella, 1999. "Bank Bailouts," IMF Working Papers 99/106, International Monetary Fund.
  12. Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision," European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.
  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. Fabio Panetta & Thomas Faeh & Giuseppe Grande & Corrinne Ho & Michael King & Aviram Levy & Federico M. Signoretti & Marco Taboga & Andrea Zaghini, 2009. "An assessment of financial sector rescue programmes," Questioni di Economia e Finanza (Occasional Papers) 47, Bank of Italy, Economic Research and International Relations Area.
  15. Franklin Allen & Elena Carletti & Douglas Gale, 2009. "Interbank Market Liquidity and Central Bank Intervention," Economics Working Papers ECO2009/09, European University Institute.
  16. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
  17. Haizhou Huang & Charles Goodhart, 1999. "A Model of the Lender of Last Resort," FMG Discussion Papers dp313, Financial Markets Group.
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