The Lender of Last Resort: A 21st Century Approach

30 Pages Posted: 23 Jun 2004

See all articles by Xavier Freixas

Xavier Freixas

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

Bruno Parigi

Università degli Studi di Padova

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2004

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 in the absence of systemic threats. 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, The Lender of Last Resort: A 21st Century Approach (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 4525. Available at SSRN: https://ssrn.com/abstract=556201 or http://dx.doi.org/10.2139/ssrn.556201

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 )

London
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 Parigi

Università degli Studi di Padova ( email )

Via 8 Febbraio, 2
Padova, Vicenza 35122
Italy

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