Liquidity from Two Lending Facilities
32 Pages Posted: 21 Aug 2017
Date Written: August 11, 2017
During financial crises, the Lender of Last Resort (LOLR) uses lending facilities to inject critical funding into the banking sector. An important obstacle for policymakers is designing the facility so that banks are not reluctant to approach due to stigma, and attracting banks with liquidity concerns rather than those prone to risk-taking and moral hazard incentives. We use an unexpected disclosure that introduced stigma at one of two similar LOLRs during the Great Depression to evaluate whether or not banks used LOLR assistance to improve their liquidity needs using a novel trivariate model with recursive endogeneity. We find evidence that banks that approached the facility with stigma were less liquid and reduced their position of safe assets in comparison with banks that approached the facility with no stigma. Thus, stigma forced the pool of LOLR borrowers to separate into different groups of banks that ex-post revealed their liquidity preferences to policymakers. This finding informs policymakers' ex-ante decision of designing a facility that only attracts banks with liquidity concerns.
Keywords: lender of last resort, risk-taking, Great Depression, liquidity, stigma
JEL Classification: G21,G28,N12
Suggested Citation: Suggested Citation