The Lender of Last Resort: A Twenty-First Century Approach

Abstract

The classical Bagehot 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 aggregate amount of liquidity and leave to the banks the responsibility of lending uncollateralized. The object of this paper is to analyze these issues rigorously by providing a framework in which liquidity shocks cannot be distinguished from solvency ones and then asking whether there is a need for a LOLR and how it should 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 setup, 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 in crisis periods; if instead the main source of moral hazard is loan monitoring, then the interbank market should be secured and the LOLR should never intervene. (JEL: E58, 628)

Does collateral fuel moral hazard in banking?

“…2 For moral hazard in banking see Matutes and Vives (2000), Blum (2002), Chiesa (2001), Niinimäki (2001), Repullo (2004), Decamps et al (2004), Freixas et al (2004), Jeitschko and Jeung (2005), Kopecky and VanHoose (2006), Lepetit et al (2008), Kang and Liu (2008) as well as Nikitin and Smith (2008).…”

Money and Modern Banking without Bank Runs

“…For example, banks have no reserve requirements in the U.K., Canada, Australia, New Zealand and Sweden, and hold very low reserves. 30 deposits. 34 From their reserves of $24 billion, U.S. banks made on average $1.9 trillion in gross payments per day through the Federal Reserve's clearinghouse system Fedwire, 35 equivalent to a 79 times turnover ratio in reserves per day.…”

Models of Discount Window Lending: A Review

“…Deposit Insurance, Bank-Failure Resolution, and Bankers' Incentives Freixas, Parigi, and Rochet (2004) present a model where bank depositors are fully covered by deposit insurance and it is the government (i.e., the party providing insurance to depositors) that needs to design the appropriate framework to manage bankers'incentives. The optimality of deposit insurance is not addressed in the paper.…”

“…As in Freixas, Parigi, and Rochet (2004), the idea is that the bank manager needs to exert e¤ort to improve the distribution of possible investment returns, but that e¤ort is costly and not veri…able. A way to give incentives to bank managers is to allow depositors to withdraw early.…”