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The lender of last resort: liquidity provision versus the possibility of bail-out

Listed author(s):
  • Eijffinger, Sylvester C W
  • Nijskens, Rob

Banking regulation has proven to be inadequate to guard systemic stability in the recent financial crisis. Central banks have provided liquidity and ministries of finance have set up rescue programmes to restore confidence and stability. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and takes excessive risk compared to the social optimum. A Lender of Last Resort can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce a fiscal authority that is able to bail out the bank by injecting capital. This authority faces a trade-off: when it imposes strict bailout conditions, investment increases but moral hazard ensues. Milder bailout conditions reduce excessive risk taking at the expense of investment. This resembles the current situation on financial markets, in which banks take less risk but also provide less credit to the economy.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7674.

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Date of creation: Feb 2010
Handle: RePEc:cpr:ceprdp:7674
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  1. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
  2. 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.
  3. repec:cmf:wpaper:wp2005_0504 is not listed on IDEAS
  4. Charles A. E. Goodhart & Haizhou Huang, 1999. "A model of the lender of last resort," Proceedings, Federal Reserve Bank of San Francisco.
  5. Rafael Repullo, 2005. "Liquidity, Risk Taking, and the Lender of Last Resort," International Journal of Central Banking, International Journal of Central Banking, vol. 1(2), September.
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  7. Eduardo Levy Yeyati & Tito Cordella, 1999. "Bank Bailouts; Moral Hazard vs. Value Effect," IMF Working Papers 99/106, .
  8. Bank for International Settlements, 2009. "An assessment of financial sector rescue programmes," BIS Papers, Bank for International Settlements, number 48.
  9. Acharya, Viral V. & Yorulmazer, Tanju, 2007. "Too many to fail--An analysis of time-inconsistency in bank closure policies," Journal of Financial Intermediation, Elsevier, vol. 16(1), pages 1-31, January.
  10. Haizhou Huang & Charles Goodhart, 1999. "A Simple Model of an International Lender of Last Resort," FMG Discussion Papers dp336, Financial Markets Group.
  11. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  12. Xavier Freixas & Jean-Charles Rochet & Bruno M. Parigi, 2004. "The Lender of Last Resort: A Twenty-First Century Approach," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1085-1115, December.
  13. Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
  14. Xavier Freixas, 1999. "Optimal Bail Out Policy, Conditionality and Creative Ambiguity," FMG Discussion Papers dp327, Financial Markets Group.
  15. Jean-Charles Rochet & Xavier Vives, 2002. "Coordination failures and the lender of last resort: was Bagehot right after all?," LSE Research Online Documents on Economics 24928, London School of Economics and Political Science, LSE Library.
  16. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
  17. Charles M. Kahn & João A. C. Santos, 2001. "Allocating bank regulatory powers: lender of last resort, deposit insurance and supervision," BIS Working Papers 102, Bank for International Settlements.
  18. Rochet, Jean-Charles, 2004. "Macroeconomic shocks and banking supervision," Journal of Financial Stability, Elsevier, vol. 1(1), pages 93-110, September.
  19. Franklin Allen & Elena Carletti & Douglas Gale, 2009. "Interbank Market Liquidity and Central Bank Intervention," Economics Working Papers ECO2009/09, European University Institute.
  20. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  21. Bagehot, Walter, 1873. "Lombard Street: A Description of the Money Market," History of Economic Thought Books, McMaster University Archive for the History of Economic Thought, number bagehot1873.
  22. Nijskens, Rob & Wagner, Wolf, 2011. "Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1391-1398, June.
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