How Central Banks End Crises

38 Pages Posted: 3 Sep 2014 Last revised: 6 Dec 2014

See all articles by Gary B. Gorton

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER); Yale University - Yale Program on Financial Stability

Guillermo Ordoñez

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: December 2, 2014

Abstract

To end a financial crisis, the central bank is to lend freely, against good collateral, at a high rate, according to Bagehot’s Rule. We argue that in theory and in practice there is a missing ingredient to Bagehot’s Rule: secrecy. Re-creating confidence requires that the central bank lend in secret, hiding the identities of the borrowers, to prevent information about individual collateral from being produced and to create an information externality by raising the perceived value of average collateral. Ironically, the participation of "bad" borrowers, with low quality collateral, in the central bank’s lending program is a desirable part of re-creating confidence because it creates stigma. Stigma is critical to sustain secrecy because no borrower wants to reveal his participation in the lending program, and it is limited by the central bank charging a high rate for its loans.

Keywords: Central Bank, Discount Window, Financial Crisis, Confidence

JEL Classification: E32, E44, E58

Suggested Citation

Gorton, Gary B. and Ordoñez, Guillermo, How Central Banks End Crises (December 2, 2014). PIER Working Paper No. 14-025. Available at SSRN: https://ssrn.com/abstract=2490449 or http://dx.doi.org/10.2139/ssrn.2490449

Gary B. Gorton (Contact Author)

Yale School of Management ( email )

165 Whitney Ave
P.O. Box 208200
New haven, CT 06511
United States

HOME PAGE: http://mba.yale.edu/faculty/profiles/gorton.shtml

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yale University - Yale Program on Financial Stability

165 Whitney Avenue
P.O. Box 208200
New Haven, CT 06520-8200
United States

Guillermo Ordoñez

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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