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Coordination failures and the lender of last resort: was Bagehot right after all?

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  • Jean-Charles Rochet
  • Xavier Vives

Abstract

The classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), asserts that the Central Bank should lend to “illiquid but solvent” banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are e¢cient, a solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot’s view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We build a model of banks’ liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot …nd liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure policy of the Central Bank.

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File URL: http://eprints.lse.ac.uk/24928/
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Bibliographic Info

Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24928.

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Length: 41 pages
Date of creation: Feb 2002
Date of revision:
Handle: RePEc:ehl:lserod:24928

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Keywords: Central Bank policy; Interbank market; Prudential regulation; Liquidity ratio; Solvency ratio; Transparency; Prompt corrective action; Orderly failure resolution; Global games; Supermodular games;

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