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Lender of last resort and the moral hazard problem


  • Mikko Niskanen

    (Opstock Ltd. , Helsinki Finland)


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, EconWPA.
  • Handle: RePEc:wpa:wuwpma:0405016 Note: Type of Document - pdf

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    References listed on IDEAS

    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. 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.
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    More about this item


    central bank; liquidity provision; lender of last resort; moral hazard;

    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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