Who Should Act as Lender of Last Resort? An Incomplete Contracts Model
This paper presents a model of a bank subject to liquidity shocks that require borrowing from a lender of last resort. Two government agencies with different objectives may perform this function: a central bank and a deposit insurance corporation. Both agencies supervise the bank, i.e. collect nonverifiable information about its financial condition, and use this information to decide whether to support it. It is shown that the optimal institutional design involves the two agencies: the central bank being responsible for dealing with small liquidity shocks, and the deposit insurance corporation for large shocks. Furthermore, except for very small shocks, they should lend at penalty rates.
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