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Central Bank Screening, Moral Hazard, and the Lender of Last Resort Policy

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  • Mei Li

    ()
    (University of Guelph)

  • Frank Milne

    ()
    (Queen's University)

  • Junfen Qiu

    ()
    (Central University of Finance and Economics)

Abstract

This paper establishes a theoretical model to examine the LOLR policy when a central bank cannot distinguish between solvent and insolvent banks. We study two cases: a case where the central bank cannot screen insolvent banks and a case where the central bank can only imperfectly screen insolvent banks. The major results that our model produces are as follows: (1) It is impossible for any separating equilibrium to exist because insolvent banks always have an incentive to mimic solvent banks to gamble for resurrection. (2) The pooling equilibria in which, on one hand, all the banks borrow from the central bank and, on the other hand, all the banks do not borrow from the central bank, could exist given certain market beliefs off the equilibrium path. However, neither of the equilibria is socially efficient because insolvent banks will continue to hold their unproductive assets, rather than efficiently liquidating them. (3) When the central bank can screen banks imperfectly, the pooling equilibrium where all the banks borrow from the central bank becomes more likely, and the pooling equilibrium where all the banks do not borrow from the central bank becomes less likely. (4) Higher precision in central bank screening will improve social welfare not only by identifying insolvent banks and forcing them to efficiently liquidate their assets, but also by reducing moral hazard and deterring banks from choosing risky assets in the first place. (5) If a central bank can commit to a specific precision level before the banks choose their assets, rather than conducting a discretionary LOLR policy, it will choose a higher precision level to reduce moral hazard and will attain higher social welfare.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1317.pdf
File Function: First version 2013
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Bibliographic Info

Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1317.

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Length: 49 pages
Date of creation: Sep 2013
Date of revision:
Handle: RePEc:qed:wpaper:1317

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Keywords: Central Bank Screening; Moral Hazard; Lender of Last Resort;

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  1. Mei Li & Frank Milne & Junfeng Qiu, 2013. "Uncertainty in an Interconnected Financial System, Contagion," Working Papers 1304, University of Guelph, Department of Economics and Finance.
  2. 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.
  3. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
  4. Xavier Freixas & Jean-Charles Rochet, 2008. "Microeconomics of Banking, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062704, December.
  5. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
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