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Central Bank Screening, Moral Hazard, and the Lender of Last Resort Policy

Author

Listed:
  • Mei Li

    () (University of Guelph)

  • Frank Milne

    () (Queen's University)

  • Junfen Qiu

    () (Central University of Finance and Economics)

Abstract

This paper establishes a theoretical model to examine the LOLR policy when a central bank cannot distinguish between solvent and insolvent banks. We study two cases: a case where the central bank cannot screen insolvent banks and a case where the central bank can only imperfectly screen insolvent banks. The major results that our model produces are as follows: (1) It is impossible for any separating equilibrium to exist because insolvent banks always have an incentive to mimic solvent banks to gamble for resurrection. (2) The pooling equilibria in which, on one hand, all the banks borrow from the central bank and, on the other hand, all the banks do not borrow from the central bank, could exist given certain market beliefs off the equilibrium path. However, neither of the equilibria is socially efficient because insolvent banks will continue to hold their unproductive assets, rather than efficiently liquidating them. (3) When the central bank can screen banks imperfectly, the pooling equilibrium where all the banks borrow from the central bank becomes more likely, and the pooling equilibrium where all the banks do not borrow from the central bank becomes less likely. (4) Higher precision in central bank screening will improve social welfare not only by identifying insolvent banks and forcing them to efficiently liquidate their assets, but also by reducing moral hazard and deterring banks from choosing risky assets in the first place. (5) If a central bank can commit to a specific precision level before the banks choose their assets, rather than conducting a discretionary LOLR policy, it will choose a higher precision level to reduce moral hazard and will attain higher social welfare.

Suggested Citation

  • Mei Li & Frank Milne & Junfen Qiu, 2013. "Central Bank Screening, Moral Hazard, and the Lender of Last Resort Policy," Working Papers 1317, Queen's University, Department of Economics.
  • Handle: RePEc:qed:wpaper:1317
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    File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1317.pdf
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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. Mei Li & Frank Milne & Junfeng Qiu, 2016. "Uncertainty in an Interconnected Financial System, Contagion, and Market Freezes," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(6), pages 1135-1168, September.
    3. 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.
    4. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
    5. Li, Mei & Milne, Frank & Qiu, Junfeng, 2013. "Uncertainty in an Interconnected Financial System, Contagion, and Market Freezes," Queen's Economics Department Working Papers 274633, Queen's University - Department of Economics.
    6. Charles A. E. Goodhart & Haizhou Huang, 1999. "A model of the lender of last resort," Proceedings, Federal Reserve Bank of San Francisco.
    7. Mei Li & Frank Milne & Junfeng Qiu, 2013. "Uncertainty in an Interconnected Financial System, Contagion," Working Papers 1304, University of Guelph, Department of Economics and Finance.
    8. Xavier Freixas & Jean-Charles Rochet, 2008. "Microeconomics of Banking, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062704, January.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Central Bank Screening; Moral Hazard; Lender of Last Resort;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G2 - Financial Economics - - Financial Institutions and Services

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