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Limited commitment and central bank lending

  • Marvin Goodfriend
  • Jeffrey M. Lacker

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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Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

Volume (Year): (1999)
Issue (Month): Fall ()
Pages: 1-27

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Handle: RePEc:fip:fedreq:y:1999:i:fall:p:1-27
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  1. Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 473-94, July.
  2. Steven A. Sharpe, 1989. "Asymmetric information, bank lending, and implicit contracts: a stylized model of customer relationships," Finance and Economics Discussion Series 70, Board of Governors of the Federal Reserve System (U.S.).
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  4. Charles Goodhart, 1988. "The Evolution of Central Banks," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262570734, August.
  5. Jeffrey Lacker, 2001. "Collateralized Debt as the Optimal Contract," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 842-859, October.
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  10. Shockley Richard L., 1995. "Bank Loan Commitments and Corporate Leverage," Journal of Financial Intermediation, Elsevier, vol. 4(3), pages 272-301, July.
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  12. Goodfriend, M. & King, R.G., 1988. "Financial Deregulation, Monetary Policy, And Central Banking," RCER Working Papers 121, University of Rochester - Center for Economic Research (RCER).
  13. Marvin Goodfriend, 1997. "Monetary policy comes of age: a 20th century odyssey," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-22.
  14. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
  15. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," The Journal of Business, University of Chicago Press, vol. 68(3), pages 351-81, July.
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  18. Thomas H. Humphrey & Robert E. Keleher, 1984. "The Lender of Last Resort; A Historical Perspective," Cato Journal, Cato Journal, Cato Institute, vol. 4(1), pages 275-321, Spring/Su.
  19. Huberman, Gur & Kahn, Charles M., 1988. "Strategic renegotiation," Economics Letters, Elsevier, vol. 28(2), pages 117-121.
  20. Anna J. Schwartz, 1992. "The misuse of the Fed's discount window," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 58-69.
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