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The Lender of Last Resort: A 21th Century Approach

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  • Freixas, Xavier
  • Parigi, Bruno
  • 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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Bibliographic Info

Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 215.

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Date of creation: 2003
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Publication status: Published in Journal of the European Economic Association, vol.�2, n°6, décembre 2004, p.�1085-1115.
Handle: RePEc:ide:wpaper:594

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  1. 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.
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Citations

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Cited by:
  1. Martin Hellwig, 2005. "Market Discipline, Information Processing, and Corporate Governance," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2005_19, Max Planck Institute for Research on Collective Goods.
  2. Pablo Druck & Mario Dehesa, 2008. "The Eastern Caribbean Central Bank," IMF Working Papers 08/214, International Monetary Fund.
  3. 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.
  4. 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).
  5. 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.
  6. 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.
  7. Raphael H. Solomon, 2005. "Pocket Banks and Out-of-Pocket Losses: Links between Corruption and Contagion," Working Papers 05-23, Bank of Canada.
  8. Itai Agur, 2009. "Regulatory Competition and Bank Risk Taking," DNB Working Papers 213, Netherlands Central Bank, Research Department.
  9. 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.
  10. 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.
  11. 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.

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