The Lender of Last Resort: A 21st Century Approach

39 Pages Posted: 19 Jan 2004  

Xavier Freixas

Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR); Barcelona Graduate School of Economics (Barcelona GSE)

Bruno Maria Parigi

University of Padua - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Jean-Charles Rochet

University of Zurich - Swiss Banking Institute (ISB); University of Toulouse I - Institut d'Economie Industrielle (IDEI); Swiss Finance Institute

Multiple version iconThere are 2 versions of this paper

Date Written: December 2003

Abstract

The classical Bagehot's conception of a Lender of Last Resort (LOLR) that lends to illiquid banks has been criticized on two grounds: on the one hand, the distinction between insolvency and illiquidity is not clear cut; on the other a fully collateralized repo market allows Central Banks to provide the adequate aggregated amount of liquidity and leave the responsibility of lending uncollateralized to the banks. The object of this paper is to analyze rigorously these issues by providing a framework where liquidity shocks cannot be distinguished from solvency ones and ask whether there is a need for a LOLR and how should it operate. Determining the optimal LOLR policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our set up, the results depend upon the existence of moral hazard. If the main source of moral hazard is the banks' lack of incentives to screen loans, then the LOLR may have to intervene to improve the efficiency of an unsecured interbank market; if instead, the main source of moral hazard is loans monitoring, then the interbank market should be secured and the LOLR should never intervene.

Keywords: Lender of Last Resort, Interbank Market, Liquidity

JEL Classification: E58, G28

Suggested Citation

Freixas, Xavier and Parigi, Bruno Maria and Rochet, Jean-Charles, The Lender of Last Resort: A 21st Century Approach (December 2003). ECB Working Paper No. 298. Available at SSRN: https://ssrn.com/abstract=487484

Xavier Freixas (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
+34 93 542 2726 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~freixas

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

HOME PAGE: http://www.econ.upf.es/~freixas/more/personal1.htm

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Bruno Maria Parigi

University of Padua - Department of Economics ( email )

via Del Santo 33
Padova, 35123
Italy

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Jean-Charles Rochet

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

University of Toulouse I - Institut d'Economie Industrielle (IDEI) ( email )

Manufacture des Tabacs
21 Allee de Brienne bat. F
Toulouse Cedex, F-31000
France
+33 5 6112 8641 (Phone)
+33 5 6112 8637 (Fax)

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

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