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Lender of Last Resort Policy in a Global Game and the Role of Depositors Aggregate Behavior as Signaling

Author

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  • Junnosuke Shino

    () (Rutgers University)

Abstract

Recent funding problems experienced by European sovereigns and the subsequent policy actions taken by European authorities have renewed interest in the international Lender of Last Resort (LLR). This paper constructs a global game LLR model applicable to both domestic and international contexts, and revisits Bagehot’s classical statements about the LLR. Compared with the existing literature, our model can be characterized by the following assumptions: (1) the (domestic or international) LLR authority is an explicit player whose preference is based on the soundness of its own balance sheet as well as on whether commercial banks fail, (2) the authority cannot distinguish solvency and insolvency of the LLR user ex ante, (3) LLR lending rates are endogenously determined, and (4) the authority’s decision making is set after observing depositors’ aggregate behaviors. With this setup, we show that: (1) depositors’ aggregate behavior of withdrawing their deposits operates as a perfect signal to the LLR authority about solvency, (2) the authority’s optimal policy is to help only illiquid but solvent banks, (3) whenever the LLR facility is utilized, optimal lending rates are strictly positive, and (4) this optimal lending rates are punitive in the sense that they take the highest level possible under the restriction that the rates enable solvent but illiquid banks to survive. These results generally support Bagehot’s statements as well as historical and current operations of LLR taken by international institutions and central banks.

Suggested Citation

  • Junnosuke Shino, 2010. "Lender of Last Resort Policy in a Global Game and the Role of Depositors Aggregate Behavior as Signaling," Departmental Working Papers 201007, Rutgers University, Department of Economics.
  • Handle: RePEc:rut:rutres:201007
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    File URL: http://www.sas.rutgers.edu/virtual/snde/wp/2010-07.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. Carlsson, Hans & van Damme, Eric, 1993. "Global Games and Equilibrium Selection," Econometrica, Econometric Society, vol. 61(5), pages 989-1018, September.
    3. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2003. "Coordination and Policy Traps," NBER Working Papers 9767, National Bureau of Economic Research, Inc.
    4. Corsetti, Giancarlo & Guimaraes, Bernardo & Roubini, Nouriel, 2006. "International lending of last resort and moral hazard: A model of IMF's catalytic finance," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 441-471, April.
    5. Chris Edmond, 2013. "Information Manipulation, Coordination, and Regime Change," Review of Economic Studies, Oxford University Press, vol. 80(4), pages 1422-1458.
    6. Christophe Chamley, 1999. "Coordinating Regime Switches," The Quarterly Journal of Economics, Oxford University Press, vol. 114(3), pages 869-905.
    7. Junnosuke Shino & Kouji Takahashi, 2010. "Sovereign Credit Default Swaps: Market Developments and Factors behind Price Changes," Bank of Japan Review Series 10-E-2, Bank of Japan.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Lender of Last Resort (LLR); Global Game; Signaling;

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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