Making it Worse: Banking Crises, Macroeconomic Risk and the Limitations to the Lender of Last Resort
10 Pages Posted: 6 Mar 2008 Last revised: 29 Jan 2018
Date Written: 2007
When considering the issue of bank rescues there is a tradeoff between crisis prevention and moral hazard. The literature has so far concentrated on the two extreme, and heavily criticised, cases of no LOLR and the unconstrained LOLR. This paper considers an intermediate case, where the limited access to real resources to recapitalise a bank leads to a partial LOLR. Although this helps to alleviate the moral hazard problem induced by lenient rescue policies a new source of moral hazard arises. Once the LOLR takes into account the social cost of failure banks have an incentive to increase this cost at the expense of monitoring. In addition when the resources are limited banks have a further incentive to be the ones to receive a rescue when other banks are in distress at the same time.
Keywords: Lender of Last Resort, banking, banking crises
JEL Classification: G21, G20
Suggested Citation: Suggested Citation