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Lender of last resort and the moral hazard problem

  • Niskanen , Mikko

    (Bank of Finland Research)

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    The paper considers a model in which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

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    Paper provided by Bank of Finland in its series Research Discussion Papers with number 17/2002.

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    Length: 36 pages
    Date of creation: 10 Jul 2002
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2002_017
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
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