Who Should Act as Lender of Last Resort? An Incomplete Contracts Model
Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Journal of Money, Credit and Banking, Vol. 32, No. 3, Part II, August 2000 "What Should Central Banks Do?: A conference sponsored by the Federal Reserve Bank of Cleveland, Oct. 27-29, 1999, Joseph G. Haubrich, Special Issue Editor"
This paper presents a model of a bank subject to liquidity shocks that require borrowing from a lender of last resort. Two government agencies may perform this function: a central bank and a deposit insurance corporation. The agencies share supervisory information, which provides a nonverifiable signal of the bank's financial condition, and use it to decide whether to support it. It is shown that the optimal institutional design involves the two agencies: the central bank dealing with small liquidity shocks, and the deposit insurance corporation with large shocks. Furthermore, except for very small shocks, they should lend at penalty rates.
JEL Classification: E58, G21, G28Accepted Paper Series
Date posted: October 26, 2000
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