Systemic Risk, Interbank Market Contagion, and the Lender of Last Resort Function
Posted: 11 Apr 2016 Last revised: 16 May 2017
Date Written: August 2, 2016
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: Suggested Citation