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Lender of last resort and the moral hazard problem

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Author Info
Mikko Niskanen (Opstock Ltd. , Helsinki Finland)
Abstract

The paper considers a modelin which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

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Paper provided by EconWPA in its series Macroeconomics with number 0405016.

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Date of creation: 14 May 2004
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Handle: RePEc:wpa:wuwpma:0405016

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Related research
Keywords: central bank; liquidity provision; lender of last resort; moral hazard;

Find related papers by JEL classification:
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
G0 - Financial Economics - - General
G2 - Financial Economics - - Financial Institutions and Services

This paper has been announced in the following NEP Reports:

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  1. Hasan , Iftekhar & Sarkar, Sudipto, 2002. "Banks’ option to lend, interest rate sensitivity, and credit availability," Research Discussion Papers 15/2002, Bank of Finland. [Downloadable!]
    Other versions:
  2. Junttila, Juha, 2002. "Forecasting the macroeconomy with current financial market information: Europe and the United States," Research Discussion Papers 2/2002, Bank of Finland. [Downloadable!]
  3. Francis, Bill B & Hasan, Iftekhar & Hunter , Delroy M., 2002. "Return-volatility linkages in the international equity and currency markets," Research Discussion Papers 9/2002, Bank of Finland. [Downloadable!]
    Other versions:
  4. Hyytinen, Ari & Kuosa, Iikka & Takalo, Tuomas, 2002. "Law of finance: Evidence from Finland," Research Discussion Papers 8/2002, Bank of Finland. [Downloadable!]
    Other versions:
  5. Matti Keloharju & Markku Malkamäki & Kjell G. Nyborg & Kristian Rydqvist, 2004. "A descriptive analysis of the Finnish treasury bond market 1991–1999," Finance 0405017, EconWPA. [Downloadable!]
    Other versions:
  6. Hasan, Iftekhar & Malkamäki, Markku & Schmiedel, Heiko, 2002. "Technology, automation, and productivity of stock exchanges: International evidence," Research Discussion Papers 4/2002, Bank of Finland. [Downloadable!]
    Other versions:
  7. Kaushik Mitra & Seppo Honkapohja, 2004. "Performance of Monetary Policy with Internal Central Bank Forecasting," Royal Holloway, University of London: Discussion Papers in Economics 04/18, Department of Economics, Royal Holloway University of London, revised Jul 2004. [Downloadable!]
    Other versions:
  8. Kanniainen, Vesa & Leppämäki, Mikko, 2002. "Financial institutions and the allocation of talent," Research Discussion Papers 5/2002, Bank of Finland. [Downloadable!]
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