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Optimal bail out policy, conditionality and constructive ambiguity

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Abstract

This paper addresses the issue of the optimal behaviour of the Lender of Last Resort (LOLR) in its microeconomic role regarding individual financial institutions in distress. It has been argued that the LOLR should not intervene at the microeconomic level and let any defaulting institution face the market discipline, as it will be confronted with the consequences of the risks it has taken. By considering a simple cost benefit analysis we show that this position may lack a sufficient foundation. We establish that, instead, uder reasonable assumptions, the optimal policy has to be conditional on the amount of uninsured debt issued by the defaulting bank. Yet in equilibrium, because the rescue policy is costly, the LOLR will not rescue all the banks that fulfill the uninsured debt requirement condition, but will follow a mixed strategy. This we interpret as the confirmation of the "creative ambiguity" principle, perfectly in line with the central bankers claim that it is efficient for them to have discretion in lending to individual institutions. Alternatively, in other cases, when the social cost of a bank's bankruptcy is too high, it is optimal for the LOLR to bail out the insititution, and this gives support to the "too big to fail" policy.

Suggested Citation

  • Xavier Freixas, 1999. "Optimal bail out policy, conditionality and constructive ambiguity," Economics Working Papers 400, Department of Economics and Business, Universitat Pompeu Fabra.
  • Handle: RePEc:upf:upfgen:400
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    References listed on IDEAS

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    1. Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-638, August.
    2. Paul Hoffman & Anthony M. Santomero, 1998. "Problem Bank Resolution: Evaluating the Options," Center for Financial Institutions Working Papers 98-05, Wharton School Center for Financial Institutions, University of Pennsylvania.
    3. Flannery, Mark J, 1996. "Financial Crises, Payment System Problems, and Discount Window Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 804-824, November.
    4. Michael D. Bordo, 1990. "The lender of last resort : alternative views and historical experience," Economic Review, Federal Reserve Bank of Richmond, issue Jan, pages 18-29.
    5. Dirk Schoenmaker, 1992. "Institutional Separation between Supervisory and Monetary Agencies," FMG Special Papers sp52, Financial Markets Group.
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    Keywords

    Banks; bail-out; Lender of Last Resort; constructive ambiguity;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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