Surviving the Perfect Storm: The Role of the Lender of Last Resort
Banco de Portugal, Working Papers 2016
66 Pages Posted: 12 Oct 2016 Last revised: 4 Nov 2020
Date Written: November 04, 2020
When banks are hit by a severe liquidity shock, central banks have a key role as lenders of last resort. Despite the well-established importance of this mechanism, it is challenging to analyze empirically this key role of central banks. We explore a unique setting in which banks suddenly lost access to market funding due to contagion fears at the onset of the euro area sovereign debt crisis. Using monthly data at the loan, bank, and firm level, we test the role of the central bank in a scenario of imminent collapse. We find that the liquidity obtained from the central bank played a key role in temporarily supporting the supply of credit to the real economy. However, the subdued loan demand, together with moral suasion and carry trade incentives, led to an increase in banks' sovereign bond holdings using central bank funding.
Keywords: lender of last resort, monetary policy, credit channel, financial crisis
JEL Classification: E44, E5, G21
Suggested Citation: Suggested Citation