Complementing Bagehot: Illiquidity and Insolvency Resolution

33 Pages Posted: 1 Nov 2011

See all articles by Sylvester C. W. Eijffinger

Sylvester C. W. Eijffinger

Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Rob Nijskens

De Nederlandsche Bank

Date Written: October 2011

Abstract

During the recent financial crisis, central banks have provided liquidity and governments have set up rescue programmes to restore confidence and stability, often against the LLR principle advocated by Bagehot. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and monitors too little. A central bank can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce an additional authority that is able to bail out the bank either by injecting capital at a fixed return or by receiving an equity claim. This authority faces a trade-off: demanding a fixed premium increases investment but worsens moral hazard. Request for an equity claim by the fiscal authority reduces excessive risk taking at the expense of investment. This resembles the current situation on financial markets, in which banks take less risk but also provide less credit to the economy

Keywords: Bailout, Bank Regulation, Capital, Lender of Last Resort, Liquidity

JEL Classification: E58, G21, G28

Suggested Citation

Eijffinger, Sylvester C. W. and Nijskens, Rob, Complementing Bagehot: Illiquidity and Insolvency Resolution (October 2011). CEPR Discussion Paper No. DP8603, Available at SSRN: https://ssrn.com/abstract=1952470

Sylvester C. W. Eijffinger (Contact Author)

Tilburg University (CentER) - Department of Economics ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2411 (Phone)
+31 13 466 3042 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Rob Nijskens

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands
+31 20 524 3234 (Phone)

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