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The Signaling Effect and Optimal LOLR Policy

Author

Listed:
  • Mei Li

    () (Department of Economics and Finance, University of Guelph)

  • Frank Milne

    () (Department of Economics, Queen’s University)

  • Junfeng Qiu

    () (China Economics and Management Academy, Central University of Finance and Economics)

Abstract

When a central bank implements the LOLR policy in a financial crisis, bank creditors often infer a bank’s quality from whether or not it borrows from the central bank. We establish a formal model to study the optimal LOLR policy in the presence of this signaling effect, assuming that the central bank aims to encourage central bank borrowing to avoid inefficiencies caused by contagion. In our model, there are two types of banks: a high quality type with high expected asset returns and a low quality type with lower returns. Both types of banks need to roll over their short-term debts. A central bank offers to lend to both types of banks. After private creditors observe whether banks borrow from the central bank, banks try to borrow from the private market. We find that there may exist a separating equilibrium where only low quality banks borrow from the central bank; and two pooling equilibria where both types of banks do and do not borrow from the central bank. Our major results are as follows: (1) Considering the signaling effect, the central bank should set its lending rate lower than the prevailing market rate to induce both types of banks to borrow from the central bank. (2) Hiding the identity of banks borrowing from the central bank will encourage banks to borrow from the central bank. (3) The central bank may serve as a coordinator for the realization of its favored equilibrium.

Suggested Citation

  • Mei Li & Frank Milne & Junfeng Qiu, 2016. "The Signaling Effect and Optimal LOLR Policy," Working Papers 1601, University of Guelph, Department of Economics and Finance.
  • Handle: RePEc:gue:guelph:2016-01
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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.
    2. Huberto Ennis & John Weinberg, 2013. "Over-the-counter loans, adverse selection, and stigma in the interbank market," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(4), pages 601-616, October.
    3. Charles A. E. Goodhart & Haizhou Huang, 1999. "A model of the lender of last resort," Proceedings, Federal Reserve Bank of San Francisco.
    4. Xavier Freixas & Jean-Charles Rochet, 2008. "Microeconomics of Banking, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062704, November.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Signaling; Lender of Last Resort;

    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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