Banking Crises and the Lender of Last Resort: How Crucial is the Role of Information?

Abstract:     
This article develops a model of bank runs and crises and analyses how the presence of a lender of last resort (LOLR) affects the solvency of the banking system. Our results indicate that the LOLR plays a productive role in the economy as long as it is perfectly informed about bank fundamentals since it can bail out solvent but illiquid banks. However, in practice policymakers cannot always distinguish between solvent and insolvent banks. We find that in such scenarios the presence of LOLR is conducive to moral hazard. The study finds that the gains from ex post efficiency may be outweighed by ex ante inefficiency induced by moral hazard for high enough noise in the LOLR's information set.

Number of Pages in PDF File: 37

Keywords: Bank runs, lender of last resort, transparency

JEL Classification: E58, G21, G28

working papers series