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

43 Pages Posted: 25 Feb 2007 Last revised: 11 Feb 2015

Date Written: November 26, 2014

Abstract

This article develops a model that studies how the presence of a lender of last resort (LOLR) affects the ex ante investment incentives of banks. We show that a perfectly informed LOLR induces a first-best outcome for small and medium sized banks but causes moral hazard in larger banks given the high contagion cost of their failure. On the other hand, an imperfectly informed LOLR causes allocational inefficiencies in the investment decisions of smaller banks but mitigates the moral hazard problem in larger banks due to the constructive ambiguity nature of bail-outs when the LOLR's information set is noisy. Policy implications include stricter supervision for smaller banks, and "buffer" requirements complemented with liquidity provision at penalty rates for larger banks.

Keywords: Bank runs, lender of last resort, moral hazard

JEL Classification: E58, G21, G28

Suggested Citation

Naqvi, Hassan, Banking Crises and the Lender of Last Resort: How Crucial is the Role of Information? (November 26, 2014). Journal of Banking and Finance 54, pp. 20-29, 2015, Available at SSRN: https://ssrn.com/abstract=512702 or http://dx.doi.org/10.2139/ssrn.512702

Hassan Naqvi (Contact Author)

Monash University ( email )

Wellington Road
Clayton, Victoria 3168
Australia