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Systemic Risk, Interbank Market Contagion, and the Lender of Last Resort Function

Posted: 11 Apr 2016 Last revised: 16 May 2017

Michael Bowe

University of Manchester

Olga Kolokolova

University of Manchester - Manchester Business School

Marcin Michalski

University of Manchester - Manchester Business School

Date Written: August 2, 2016

Abstract

We develop a theoretical model examining the financial stability policy of a central bank serving as both the lender of last resort and the regulator of the financial system. The model accommodates the possibility of financial contagion through interbank market linkages, and adverse feedback from the financial system to the real economy. It identifies the relative riskiness of the agents in the financial system, the probability of systemic distress, and the expected duration of credit supply reduction as the key factors influencing the design of financial stability policy. Model simulations indicate the existence of a substitution effect between reducing the expected scope of a central bank's assistance to an institution in distress and increasing bank reserve requirements.

Keywords: Financial Stability, Central Bank Policy, Lender of Last Resort, Banking Crisis, Bank Regulation, Interbank Market

JEL Classification: E58, G01, G21, G28

Suggested Citation

Bowe, Michael and Kolokolova, Olga and Michalski, Marcin, Systemic Risk, Interbank Market Contagion, and the Lender of Last Resort Function (August 2, 2016). Available at SSRN: https://ssrn.com/abstract=2760879 or http://dx.doi.org/10.2139/ssrn.2760879

Michael Bowe

University of Manchester ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom
+44 161 306 3407 (Phone)
+44 161 275 4023 (Fax)

Olga Kolokolova

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom
+44-161-306-2081 (Phone)

HOME PAGE: http://www.mbs.ac.uk/research/academicdirectory/profiles/olga.kolokolova.aspx

Marcin Michalski (Contact Author)

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

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