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Lender of last resort and the moral hazard problem

  • Mikko Niskanen

    (Opstock Ltd. , Helsinki Finland)

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    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.

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    File URL: http://econwpa.repec.org/eps/mac/papers/0405/0405016.pdf
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    Paper provided by EconWPA in its series Macroeconomics with number 0405016.

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    Date of creation: 14 May 2004
    Date of revision:
    Handle: RePEc:wpa:wuwpma:0405016
    Note: Type of Document - pdf
    Contact details of provider: Web page: http://econwpa.repec.org

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    1. 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.
    2. Kanniainen, Vesa & Leppämäki, Mikko, 2002. "Financial institutions and the allocation of talent," Research Discussion Papers 5/2002, Bank of Finland.
    3. Honkapohja, Seppo & Mitra, Kaushik, 2002. "Performance of monetary policy with internal central bank forecasting," Working Paper Series 0127, European Central Bank.
    4. Hasan, Iftekhar & Malkamäki, Markku & Schmiedel, Heiko, 2002. "Technology, automation, and productivity of stock exchanges: International evidence," Research Discussion Papers 4/2002, Bank of Finland.
    5. 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.
    6. Hasan , Iftekhar & Sarkar, Sudipto, 2002. "Banks’ option to lend, interest rate sensitivity, and credit availability," Research Discussion Papers 15/2002, Bank of Finland.
    7. Bill B. Francis & Iftekhar Hasan & Delroy M. Hunter, 2004. "Return-volatility linkages in the international equity and currency markets," Finance 0405022, EconWPA.
    8. Junttila, Juha, 2002. "Forecasting the macroeconomy with current financial market information: Europe and the United States," Research Discussion Papers 2/2002, Bank of Finland.
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