Coordination Failures and the Lender of Last Resort: Was Bagehot Right after All?

45 Pages Posted: 21 Mar 2002

See all articles by Jean-Charles Rochet

Jean-Charles Rochet

Swiss Finance Institute; University of Geneva - Geneva Finance Research Institute (GFRI); University of Zurich - Swiss Banking Institute (ISB)

Xavier Vives

University of Navarra - IESE Business School; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Date Written: February 2002

Abstract

The classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), asserts that the Central Bank should lend to 'illiquid but solvent' banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are efficient, a solvent bank cannot be illiquid. This Paper provides a possible theoretical foundation for rescuing Bagehot's view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We build a model of banks' liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure policy of the Central Bank.

Keywords: Central bank policy, interbank market, prudential regulation, liquidity ratio, solvency ratio, transparency, prompt corrective action, orderly failure resolution, global games, supermodular games

JEL Classification: G28

Suggested Citation

Rochet, Jean-Charles and Vives, Xavier, Coordination Failures and the Lender of Last Resort: Was Bagehot Right after All? (February 2002). Available at SSRN: https://ssrn.com/abstract=304645

Jean-Charles Rochet (Contact Author)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

Xavier Vives

University of Navarra - IESE Business School ( email )

Avenida Pearson 21
Barcelona, 08034
Spain

HOME PAGE: http://wwwapp.iese.edu/faculty/facultyDetail.asp?lang=en&prof=xv

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany