Emergency Liquidity Provision to Public Banks: Rules Versus Discretion

Abstract

This paper analyzes a government's incentives to provide financial assistance to a public bank which is hit by a liquidity shock. We show that discretionary decisions about emergency liquidity assistance result in either excessively small or excessively large liquidity injections in a wide variety of circumstances. Also, adding a lender of last resort does not generally ensure a socially optimal policy. However, optimal rules exist that align the government's preferences with social preferences by either subsidizing or taxing liquidity aid.

Keywords: Public banking, liquidity crises, lender of last resort, central bank, deposit insurance, forbearance

JEL Classification: G21, G28, L32