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Liquidity, Risk Taking, and the Lender of Last Resort

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  • Repullo, Rafael

Abstract

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 826.

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Date of creation: 28 Feb 2005
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Publication status: Published in International Journal of Central Banking Number 2.Volume(2005): pp. 47-80
Handle: RePEc:pra:mprapa:826
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  • G00 - Financial Economics - - General - - - General
  • G0 - Financial Economics - - General

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  1. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Department of Economics Working Papers 2008-07, Department of Economics, Williams College.
  2. Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.
  3. Andrea Prat, 2002. "The Wrong Kind of Transparency," STICERD - Theoretical Economics Paper Series 439, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  4. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 663-691.
  5. Repullo, Rafael, 2003. "Capital Requirements, Market Power and Risk-Taking in Banking," CEPR Discussion Papers 3721, C.E.P.R. Discussion Papers.
  6. Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
  7. Goodfriend, M. & King, R.G., 1988. "Financial Deregulation, Monetary Policy, And Central Banking," RCER Working Papers 121, University of Rochester - Center for Economic Research (RCER).
  8. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
  9. Patrick Bolton & Xavier Freixas, 2000. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 324-351, April.
  10. Charles M. Kahn & João A.C. Santos, 2001. "Allocating bank regulatory powers: lender of last resort, deposit insurance, and supervision," Proceedings 717, Federal Reserve Bank of Chicago.
  11. Douglas W. Diamond & Raghuram G. Rajan, . "A Theory of Bank Capital," CRSP working papers 363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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  13. Eduardo Levy Yeyati & Tito Cordella, 1999. "Bank Bailouts; Moral Hazard vs. Value Effect," IMF Working Papers 99/106, International Monetary Fund.
  14. Rochet, Jean-Charles & Vives, Xavier, 2002. "Coordination failures and the lender of last resort : was Bagehot right after all?," HWWA Discussion Papers 184, Hamburg Institute of International Economics (HWWA).
  15. Repullo, Rafael, 2004. "Policies for Banking Crises: A Theoretical Framework," CEPR Discussion Papers 4727, C.E.P.R. Discussion Papers.
  16. Repullo, R., 1999. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Papers 9913, Centro de Estudios Monetarios Y Financieros-.
  17. X. Freixas, 2000. "Optimal Bail Out Policy, Conditionality and Constructive Ambiguity," DNB Staff Reports (discontinued) 49, Netherlands Central Bank.
  18. Martin Gonzalez Eiras, 2003. "Bank's Liquidity Demand in the Presence of a Lender of Last Resort," Working Papers 61, Universidad de San Andres, Departamento de Economia, revised Sep 2003.
  19. Xavier Freixas & Curzio Giannini & Glenn Hoggarth & Farouk Soussa, 2000. "Lender of Last Resort: What Have We Learned Since Bagehot?," Journal of Financial Services Research, Springer;Western Finance Association, vol. 18(1), pages 63-84, October.
  20. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
  21. Benjamin A. Friedman & E. Gerald Corrigan & Irvine H. Sprague & Norman Strunk & Joseph A. Grundfest, 1991. "The Risks of Financial Crises," NBER Chapters, in: The Risk of Economic Crisis, pages 19-83 National Bureau of Economic Research, Inc.
  22. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  23. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
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