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

  • Junnosuke Shino

    ()

    (Rutgers University)

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 Bagehotfs 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 authorityfs decision making is set after observing depositorsf aggregate behaviors. With this setup, we show that: (1) depositorsf aggregate behavior of withdrawing their deposits operates as a perfect signal to the LLR authority about solvency, (2) the authorityfs 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 Bagehotfs statements as well as historical and current operations of LLR taken by international institutions and central banks.

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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201007.

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Length: 20 pages
Date of creation: 23 Sep 2010
Date of revision:
Handle: RePEc:rut:rutres:201007
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  1. Giancarlo Corsetti & Bernardo Guimaraes & Nouriel Roubini, 2003. "International Lending of Last Resort and Moral Hazard: A Model of IMF's Catalytic Finance," NBER Working Papers 10125, National Bureau of Economic Research, Inc.
  2. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2004. "Coordination and Policy Traps," Levine's Bibliography 122247000000000294, UCLA Department of Economics.
  3. Carlsson, H. & van Damme, E.E.C., 1993. "Global games and equilibrium selection," Other publications TiSEM 49a54f00-dcec-4fc1-9488-4, School of Economics and Management.
  4. repec:dgr:kubcen:199052 is not listed on IDEAS
  5. Christophe Chamley, 1999. "Coordinating Regime Switches," The Quarterly Journal of Economics, MIT Press, vol. 114(3), pages 869-905, August.
  6. Chris Edmond, 2011. "Information Manipulation, Coordination, and Regime Change," NBER Working Papers 17395, National Bureau of Economic Research, Inc.
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