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Lender of last resort and the moral hazard problem

Author

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  • Mikko Niskanen

    (Opstock Ltd. , Helsinki Finland)

Abstract

The paper considers a modelin which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

Suggested Citation

  • Mikko Niskanen, 2004. "Lender of last resort and the moral hazard problem," Macroeconomics 0405016, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpma:0405016
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    References listed on IDEAS

    as
    1. Junttila, Juha, 2002. "Forecasting the macroeconomy with current financial market information : Europe and the United States," Research Discussion Papers 2/2002, Bank of Finland.
    2. Honkapohja, Seppo & Mitra, Kaushik, 2005. "Performance of monetary policy with internal central bank forecasting," Journal of Economic Dynamics and Control, Elsevier, vol. 29(4), pages 627-658, April.
    3. Schmiedel, Heiko, 2002. "Total factor productivity growth in European stock exchanges : A non-parametric frontier approach," Research Discussion Papers 11/2002, Bank of Finland.
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    6. Iftekhar Hasan & Sudipto Sarkar, 2002. "Banks' option to lend, interest rate sensitivity, and credit availability," Review of Derivatives Research, Springer, vol. 5(3), pages 213-250, October.
    7. Keloharju, Matti & Malkamäki, Markku & Nyborg, Kjell G. & Rydqvist, Kristian, 2002. "A Descriptive analysis of the finnish treasury bond market 1991-1999," Research Discussion Papers 16/2002, Bank of Finland.
    8. Hasan, Iftekhar & Malkamaki, Markku & Schmiedel, Heiko, 2003. "Technology, automation, and productivity of stock exchanges: International evidence," Journal of Banking & Finance, Elsevier, vol. 27(9), pages 1743-1773, September.
    9. Niskanen, Mikko, 2002. "Lender of last resort and the moral hazard problem," Research Discussion Papers 17/2002, Bank of Finland.
    10. Pohjola, Tapio, 2002. "Effects of fiscal policy on the durability of low inflation regimes," Research Discussion Papers 14/2002, Bank of Finland.
    11. Ari Hyytinen & Iikka Kuosa & Tuomas Takalo, 2003. "Law or Finance: Evidence from Finland," European Journal of Law and Economics, Springer, vol. 16(1), pages 59-89, July.
    12. Kanniainen, Vesa & Leppämäki, Mikko, 2002. "Financial institutions and the allocation of talent," Research Discussion Papers 5/2002, Bank of Finland.
    13. Iftekhar Hasan & Sudipto Sarkar, 2002. "Banks' option to lend, interest rate sensitivity, and credit availability," Review of Derivatives Research, Springer, vol. 5(3), pages 213-250, October.
    14. Honkapohja, Seppo & Mitra, Kaushik, 2005. "Performance of monetary policy with internal central bank forecasting," Journal of Economic Dynamics and Control, Elsevier, vol. 29(4), pages 627-658, April.
    15. Francis, Bill B. & Hasan, Iftekhar & Hunter, Delroy M., 2002. "Return-volatility linkages in the international equity and currency markets," Bank of Finland Research Discussion Papers 9/2002, Bank of Finland.
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    Cited by:

    1. Cecile Bastidon & Philippe Gilles & Nicolas Huchet, 2008. "A Selective Bail-Out International Lending of Last Resort Model," Annals of Economics and Finance, Society for AEF, vol. 9(1), pages 103-114, May.

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    Keywords

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    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G0 - Financial Economics - - General
    • G2 - Financial Economics - - Financial Institutions and Services

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