Limited Commitment and Central Bank Lending
28 Pages Posted: 26 Nov 2012
Date Written: January 26, 1999
Central bank or International Monetary Fund lending should be regarded as a line of credit, analogous to private line-of-credit products. Contractual provisions in private line-of-credit arrangements are designed to control managerial moral hazard and provide a means for profit-maximizing lenders to credibly commit to withdraw credit and induce closure when appropriate. The contractual mechanisms utilized by private line-of-credit providers are not effective for a central bank whose primary mission — to maintain financial system stability — can override its obligation to protect public funds and undercut its ability to limit its lending reach. We consider in some detail five broad approaches to a central bank’s commitment problem: good offices only, collateralization and early intervention, constructive ambiguity, extending supervisory and regulatory reach, and reputation building. Our analysis suggests that the first four institutional approaches cannot be counted on to overcome the fundamental forces inducing a central bank to lend. We argue that the only practical way for a central bank to credibly limit lending is for it to build up over time a reputation for restraint.
Keywords: Central banks, International Monetary Fund, discount window, lender of last resort, loan commitments, moral hazard, reputation, constructive ambiguity, financial stability
JEL Classification: E44, E58, F33
Suggested Citation: Suggested Citation