Optimal Bail Out Policy, Conditionality and Constructive Ambiguity

Working Paper No. 400

31 Pages Posted: 15 Dec 1999

See all articles by Xavier Freixas

Xavier Freixas

Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR); Barcelona Graduate School of Economics (Barcelona GSE)


This paper addresses the issue of the optimal behaviour of the Lender of Last Resort (LOLR) in its microeconomic role regarding individual financial institutions in distress. It has been argued that the LOLR should not intervene at the microeconomic level and let any defaulting institution face the market discipline, as it will be confronted with the consequences of the risks it has taken. By considering a simple cost benefit analysis we show that this position may lack a sufficient foundation. We establish that, instead, uder reasonable assumptions, the optimal policy has to be conditional on the amount of uninsured debt issued by the defaulting bank. Yet in equilibrium, because the rescue policy is costly, the LOLR will not rescue all the banks that fulfill the uninsured debt requirement condition, but will follow a mixed strategy. This we interpret as the confirmation of the "creative ambiguity" principle, perfectly in line with the central bankers claim that it is efficient for them to have discretion in lending to individual institutions. Alternatively, in other cases, when the social cost of a bank's bankruptcy is too high, it is optimal for the LOLR to bail out the insititution, and this gives support to the "too big to fail" policy.

JEL Classification: G10, G18, E58

Suggested Citation

Freixas, Xavier, Optimal Bail Out Policy, Conditionality and Constructive Ambiguity. Working Paper No. 400, Available at SSRN: https://ssrn.com/abstract=199054 or http://dx.doi.org/10.2139/ssrn.199054

Xavier Freixas (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
+34 93 542 2726 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~freixas

Centre for Economic Policy Research (CEPR) ( email )

United Kingdom

HOME PAGE: http://www.econ.upf.es/~freixas/more/personal1.htm

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005

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