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Limited commitment and central bank lending

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Author Info
Marvin Goodfriend
Jeffrey M. Lacker

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Abstract

Central bank or International Monetary Fund lending should be regarded as a line of credit, analogous to private line-of-credit products. Contractual provisions in private line-of-credit arrangements are designed to control managerial moral hazard and provide a means for profit-maximizing lenders to credibly commit to withdraw credit and induce closure when appropriate. The contractual mechanisms utilized by private line-of-credit providers are not effective for a central bank whose primary mission—to maintain financial system stability—can override its obligation to protect public funds and undercut its ability to limit its lending reach. We consider in some detail five broad approaches to a central bank’s commitment problem: good offices only, collateralization and early intervention, constructive ambiguity, extending supervisory and regulatory reach, and reputation building. Our analysis suggests that the first four institutional approaches cannot be counted on to overcome the fundamental forces inducing a central bank to lend. We argue that the only practical way for a central bank to credibly limit lending is for it to build up over time a reputation for restraint.

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 99-02.

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Date of creation: 1999
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Handle: RePEc:fip:fedrwp:99-02

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Keywords: Banks and banking; Central ; Bank loans;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Thomas M. Humphrey & Robert E. Keleher, 1984. "The lender of last resort : a historical perspective," Working Paper 84-03, Federal Reserve Bank of Richmond. [Downloadable!]
  2. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June. [Downloadable!] (restricted)
  3. Stulz, ReneM. & Johnson, Herb, 1985. "An analysis of secured debt," Journal of Financial Economics, Elsevier, vol. 14(4), pages 501-521, December. [Downloadable!] (restricted)
  4. Marvin Goodfriend, 1997. "Monetary policy comes of age: a 20th century odyssey," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-22. [Downloadable!]
  5. Leonard I. Nakamura, 1993. "Recent research in commercial banking: information and lending," Working Papers 93-24, Federal Reserve Bank of Philadelphia.
  6. Jeffrey M. Lacker, 1998. "Collateralized debt as the optimal contract," Working Paper 98-04, Federal Reserve Bank of Richmond. [Downloadable!]
    Other versions:
  7. Huberman, Gur & Kahn, Charles M, 1988. "Limited Contract Enforcement and Strategic Renegotiation," American Economic Review, American Economic Association, vol. 78(3), pages 471-84, June. [Downloadable!] (restricted)
  8. Petersen, Mitchell A & Rajan, Raghuram G, 1995. "The Effect of Credit Market Competition on Lending Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 407-43, May. [Downloadable!] (restricted)
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  9. Anna J. Schwartz, 1992. "The misuse of the Fed's discount window," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 58-69. [Downloadable!]
  10. Sharpe, Steven A, 1990. " Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships," Journal of Finance, American Finance Association, vol. 45(4), pages 1069-87, September. [Downloadable!] (restricted)
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  11. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Working Paper 88-01, Federal Reserve Bank of Richmond. [Downloadable!]
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  12. Shockley Richard L., 1995. "Bank Loan Commitments and Corporate Leverage," Journal of Financial Intermediation, Elsevier, vol. 4(3), pages 272-301, July. [Downloadable!] (restricted)
  13. Urs W. Birchler, 1999. "Bankruptcy Priority for Bank Deposits: a Contract Theoretic Explanation," Working Papers 00.01, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
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  14. Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Blackwell Publishing, vol. 59(3), pages 473-94, July. [Downloadable!] (restricted)
  15. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," Journal of Business, University of Chicago Press, vol. 68(3), pages 351-81, July. [Downloadable!] (restricted)
  16. Berlin, Mitchell & Mester, Loretta J., 1992. "Debt covenants and renegotiation," Journal of Financial Intermediation, Elsevier, vol. 2(2), pages 95-133, June. [Downloadable!] (restricted)
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  17. repec:fip:fedreq:y:1988:i:may:p:3-22:n:v.74no.3 is not listed on IDEAS
  18. Rajan, Raghuram & Winton, Andrew, 1995. " Covenants and Collateral as Incentives to Monitor," Journal of Finance, American Finance Association, vol. 50(4), pages 1113-46, September. [Downloadable!] (restricted)
  19. Huberman, Gur & Kahn, Charles M., 1988. "Strategic renegotiation," Economics Letters, Elsevier, vol. 28(2), pages 117-121. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. John R. Walter, 2004. "Closing troubled banks : how the process works," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 51-68. [Downloadable!]
  2. Stanley Fischer, 1999. "On the Need for an International Lender of Last Resort," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 85-104, Fall. [Downloadable!] (restricted)
  3. Alina Carare & Mark R. Stone, 2003. "Inflation Targeting Regimes," IMF Working Papers 03/9, International Monetary Fund. [Downloadable!]
    Other versions:
  4. 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. [Downloadable!]
    Other versions:
  5. Erlenmaier, Ulrich & Gersbach, Hans, 2001. "The Funds Concentration Effect and Discriminatory Bailout," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  6. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Working Paper 00-03, Federal Reserve Bank of Richmond. [Downloadable!]
    Other versions:
  7. Antoine Martin & James McAndrews, 2008. "Should there be intraday money markets?," Staff Reports 337, Federal Reserve Bank of New York. [Downloadable!]
  8. Sánchez-Fung, José R., 2008. "The day-to-day interbank market, volatility, and central bank intervention in a developing economy," MPRA Paper 15648, University Library of Munich, Germany. [Downloadable!]
  9. Rafael Repullo, 2005. "Liquidity, Risk-Taking, And The Lender Of Last Resort," Working Papers wp2005_0504, CEMFI. [Downloadable!]
    Other versions:
  10. Mark R. Stone, 2003. "Inflation Targeting Lite," IMF Working Papers 03/12, International Monetary Fund. [Downloadable!]
  11. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer, vol. 18(1), pages 63-84, October. [Downloadable!] (restricted)
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