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The lender of last resort: a 21st century approach

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  • Freixas, Xavier
  • Parigi, Bruno M.
  • Rochet, Jean-Charles

Abstract

The classical Bagehot’s 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 aggregated amount of liquidity and leave the responsibility of lending uncollateralized to the banks. The object of this paper is to analyze rigorously these issues by providing a framework where liquidity shocks cannot be distinguished from solvency ones and ask whether there is a need for a LOLR and how should it operate. Determining the optimal LOLR policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our set up, 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 e?ciency of an unsecured interbank market; if instead, the main source of moral hazard is loans monitoring, then the interbank market should be secured and the LOLR should never intervene. JEL Classification: E58, G28

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Paper provided by European Central Bank in its series Working Paper Series with number 0298.

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Date of creation: Dec 2003
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Handle: RePEc:ecb:ecbwps:20030298

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Keywords: Interbank Market; Lender of Last Resort; Liquidity;

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References

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  1. Gary Gorton & Lixin Huang, 2002. "Bank Panics and the Endogeneity of Central Banking," Center for Financial Institutions Working Papers 02-29, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Leonardo Bartolini & Alessandro Prati, 2003. "The execution of monetary policy: a tale of two central banks," Economic Policy, CEPR & CES & MSH, vol. 18(37), pages 435-467, October.
  3. Repullo, Rafael, 2000. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 580-605, August.
  4. 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.
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  7. Freixas, Xavier & Parigi, Bruno & Rochet, Jean Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers 2325, C.E.P.R. Discussion Papers.
  8. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-62, November.
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  17. Philippe Aghion, Patrick Bolton & Steven Fries, 1999. "Optimal Design of Bank Bailouts: The Case of Transition Economies," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 155(1), pages 51-, March.
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Citations

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Cited by:
  1. Jean-Charles Rochet & Xavier Vives, 2002. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," FMG Discussion Papers dp408, Financial Markets Group.
  2. Hellwig, Martin, 2006. "Market Discipline, Information Processing, and Corporate Governance," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 155, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  3. Berger, Helge & Hefeker, Carsten, 2006. "Does Financial Integration Make Banks Act More Prudential? Regulation, Foreign Owned Banks, and the Lender-of-Last Resort," HWWA Discussion Papers 339, Hamburg Institute of International Economics (HWWA).
  4. Alain Ize & Miguel Kiguel & Eduardo Levy Yeyati, 2005. "Managing Systemic Liquidity Risk in Financially Dollarized Economy," Business School Working Papers managsystrisk, Universidad Torcuato Di Tella.
  5. Pablo Druck & Mario Dehesa, 2008. "The Eastern Caribbean Central Bank," IMF Working Papers 08/214, International Monetary Fund.
  6. Itai Agur, 2009. "Regulatory Competition and Bank Risk Taking," DNB Working Papers 213, Netherlands Central Bank, Research Department.
  7. Imbierowicz, Björn & Rauch, Christian, 2014. "The relationship between liquidity risk and credit risk in banks," Journal of Banking & Finance, Elsevier, vol. 40(C), pages 242-256.
  8. Eduardo Levy Yeyati & Alain Ize & Miguel A. Kiguel, 2005. "Managing Systemic Liquidity Risk in Financially Dollarized Economies," IMF Working Papers 05/188, International Monetary Fund.
  9. DeYoung, Robert & Kowalik, Michal & Reidhill, Jack, 2013. "A theory of failed bank resolution: Technological change and political economics," Journal of Financial Stability, Elsevier, vol. 9(4), pages 612-627.
  10. Raphael H. Solomon, 2005. "Pocket Banks and Out-of-Pocket Losses: Links between Corruption and Contagion," Working Papers 05-23, Bank of Canada.
  11. Bastidon, Cécile & Gilles, Philippe & Huchet, Nicolas, 2008. "The international lender of last resort and selective bail-out," Emerging Markets Review, Elsevier, vol. 9(2), pages 144-152, June.

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