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Optimal Bail Out Policy, Conditionality and Constructive Ambiguity

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Xavier Freixas ()

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Abstract

This paper addresses the issue of the optimal behaviour of the Lender of Last Resort (LOLR) in its microeconomic role regarding individual financial institutions in distress. It has been argued that the LOLR should not intervene at the microeconomic level and let any defaulting institution face the market discipline, as it will be confronted with the consequences of the risks it has taken. By considering a simple cost benefit analysis we show that this position may lack a sufficient foundation. We establish that, instead, uder reasonable assumptions, the optimal policy has to be conditional on the amount of uninsured debt issued by the defaulting bank. Yet in equilibrium, because the rescue policy is costly, the LOLR will not rescue all the banks that fulfill the uninsured debt requirement condition, but will follow a mixed strategy. This we interpret as the confirmation of the "creative ambiguity" principle, perfectly in line with the central bankers claim that it is efficient for them to have discretion in lending to individual institutions. Alternatively, in other cases, when the social cost of a bank's bankruptcy is too high, it is optimal for the LOLR to bail out the insititution, and this gives support to the "too big to fail" policy.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 400.

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Date of creation: Jun 1999
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Handle: RePEc:upf:upfgen:400

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Related research
Keywords: Banks; bail-out; Lender of Last Resort; constructive ambiguity;

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Find related papers by JEL classification:
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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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. Dirk Schoenmaker, 1992. "Institutional Separation between Supervisory and Monetary Agencies," FMG Special Papers sp52, Financial Markets Group. [Downloadable!] (restricted)
  2. Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
    Other versions:
  3. repec:fip:fedreq:y:1990:i:jan:p:18-29:n:v.76no.1 is not listed on IDEAS
  4. Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," Economics Working Papers 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999. [Downloadable!]
    Other versions:
  5. Paul Hoffman & Anthony M. Santomero, 1998. "Problem Bank Resolution: Evaluating the Options," Center for Financial Institutions Working Papers 98-05, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
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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. Andrew Kuritzkes & Til Schuermann & Scott Weiner, 2002. "Deposit Insurance and Risk Management of the U.S. Banking System: How Much? How Safe? Who Pays?," Center for Financial Institutions Working Papers 02-02, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  2. Bems, Rudolfs & Jönsson, Kristian, 2002. "Financial Crisis in Emerging Markets and the Optimal Bailout Policy," Working Paper Series in Economics and Finance 520, Stockholm School of Economics, revised 31 Oct 2003. [Downloadable!]
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