Interventions in Markets with Adverse Selection: Implications for Discount Window Stigma
Posted: 18 Jan 2017 Last revised: 9 Nov 2017
Date Written: 2017-01-09
I study the implications for central bank discount window stigma of the model by Philippon and Skreta (2012). I take an equilibrium perspective for a given discount window program instead of following the program-design approach of the original paper. This allows me to narrow the focus on the model's positive predictions. In the model, firms (banks) need to borrow to finance a productive project. There is limited liability and firms have private information about their ability to repay their debts. This creates an adverse selection problem. The central bank can ameliorate the impact of adverse selection by lending to firms. Discount window borrowing is observable and it may be taken as a signal of firms' credit worthiness. Under some conditions, firms borrowing from the discount window may pay higher interest rates to borrow in the market, a phenomenon often associated with the presence of stigma. I discuss these conditions in detail and what they suggest about the relevance of stigma as an empirical phenomenon.
Keywords: Banking, Federal Reserve, Central Bank, Policy, Lender of last resort
JEL Classification: E51, E58, G21, G28
Suggested Citation: Suggested Citation