The Lender of Last Resort: A 21st Century Approach
Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR); Barcelona Graduate School of Economics (Barcelona GSE)
Bruno Maria Parigi
University of Padua - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)
University of Zurich - Swiss Banking Institute (ISB); University of Toulouse I - Institut d'Economie Industrielle (IDEI); Ecole Polytechnique Fédérale de Lausanne - Swiss Finance Institute
ECB Working Paper No. 298
The classical Bagehot's conception of a Lender of Last Resort (LOLR) that lends to illiquid banks has been criticized on two grounds: on the one hand, the distinction between insolvency and illiquidity is not clear cut; on the other a fully collateralized repo market allows Central Banks to provide the adequate aggregated amount of liquidity and leave the responsibility of lending uncollateralized to the banks. The object of this paper is to analyze rigorously these issues by providing a framework where liquidity shocks cannot be distinguished from solvency ones and ask whether there is a need for a LOLR and how should it operate. Determining the optimal LOLR policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our set up, the results depend upon the existence of moral hazard. If the main source of moral hazard is the banks' lack of incentives to screen loans, then the LOLR may have to intervene to improve the efficiency of an unsecured interbank market; if instead, the main source of moral hazard is loans monitoring, then the interbank market should be secured and the LOLR should never intervene.
Number of Pages in PDF File: 39
Keywords: Lender of Last Resort, Interbank Market, Liquidity
JEL Classification: E58, G28
Date posted: January 19, 2004
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