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Liquidity, Risk Taking, and the Lender of Last Resort

  • Rafael Repullo

    (CEMFI and CEPR)

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 1 (2005)
Issue (Month): 2 (September)
Pages:

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Handle: RePEc:ijc:ijcjou:y:2005:q:3:a:2
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  1. Repullo, Rafael & Suarez, Javier, 2004. "Loan pricing under Basel capital requirements," Journal of Financial Intermediation, Elsevier, vol. 13(4), pages 496-521, October.
  2. Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision," European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.
  3. X. Freixas, 2000. "Optimal Bail Out Policy, Conditionality and Constructive Ambiguity," DNB Staff Reports (discontinued) 49, Netherlands Central Bank.
  4. Repullo, Rafael, 2004. "Policies for Banking Crises: A Theoretical Framework," CEPR Discussion Papers 4727, C.E.P.R. Discussion Papers.
  5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  6. Marvin Goodfriend & Jeffrey M. Lacker, 1999. "Limited commitment and central bank lending," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-27.
  7. 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.
  8. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Department of Economics Working Papers 2008-07, Department of Economics, Williams College.
  9. Rafael Repullo, 2002. "Capital requirements, market power, and risk-taking in banking," Proceedings 809, Federal Reserve Bank of Chicago.
  10. 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.
  11. 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.
  12. Martin Gonzalez Eiras, 2003. "Bank's Liquidity Demand in the Presence of a Lender of Last Resort," Working Papers 61, Universidad de San Andres, Departamento de Economia, revised Sep 2003.
  13. Cordella, Tito & Yeyati, Eduardo Levy, 2003. "Bank bailouts: moral hazard vs. value effect," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 300-330, October.
  14. Douglas W. Diamond & Raghuram G. Rajan, . "A Theory of Bank Capital," CRSP working papers 363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  15. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Economic Review, Federal Reserve Bank of Richmond, issue May, pages 3-22.
  16. Benjamin A. Friedman & E. Gerald Corrigan & Irvine H. Sprague & Norman Strunk & Joseph A. Grundfest, 1991. "The Risks of Financial Crises," NBER Chapters, in: The Risk of Economic Crisis, pages 19-83 National Bureau of Economic Research, Inc.
  17. Patrick Bolton & Xavier Freixas, 2000. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 324-351, April.
  18. Andrea Prat, 2004. "The wrong kind of transparency," LSE Research Online Documents on Economics 24712, London School of Economics and Political Science, LSE Library.
  19. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer, vol. 18(1), pages 63-84, October.
  20. Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.
  21. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
  22. 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.
  23. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
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