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Stock Liquidity Requirements and the Insurance Aspect of the Lender of Last Resort

Author

Listed:
  • Spyros Pagratis

    (Bank of England)

Abstract

This paper considers a model of information-based bank runs where a central bank sets its lender of last resort (LOLR) policy in order to maximize welfare. To mitigate the risks associated with overinvestment by the banking sector, the central bank sets prudential liquidity requirements for the banking sector in the form of a ratio of liquid assets to deposits. Liquidity requirements then provide a buffer against early deposit withdrawals, but they also allow the central bank to manufacture a distribution of costs to LOLR funding with an expected value equal to 0. It is shown that liquidity requirements, along with an appropriate LOLR policy, become welfare improving if the banking sector is characterized by high-profit opportunities, low leverage, and a relatively volatile deposit base. Otherwise, forgone productive investment due to liquidity restrictions may result in a disproportional cost to the banking sector relative to the insurance value of LOLR.

Suggested Citation

  • Spyros Pagratis, 2007. "Stock Liquidity Requirements and the Insurance Aspect of the Lender of Last Resort," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 119-146, September.
    • Handle: RePEc:ijc:ijcjou:y:2007:q:3:a:4
    as

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    References listed on IDEAS

    as
    1. Jean-Charles Rochet & Xavier Vives, 2004. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1116-1147, December.
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    3. Stephen Morris & Hyun Song Shin, 2000. "Global Games: Theory and Applications," Cowles Foundation Discussion Papers 1275, Cowles Foundation for Research in Economics, Yale University.
    4. Richard A. Posner, 1971. "Taxation by Regulation," Bell Journal of Economics, The RAND Corporation, vol. 2(1), pages 22-50, Spring.
    5. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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