A Model of the Lender of Last Resort

Author: Mr. Haizhou Huang and Mr. C. A. E. Goodhart

Volume/Issue: Volume 1999 Issue 039

Publication date: March 1999

ISBN: 9781451845815

$20.00

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Topics covered in this book

This title contains information about the following subjects. Click on a subject if you would like to see other titles with the same subjects.

Banks and Banking , Finance , WP , central bank , Banking Crises , Financial Contagion , Moral Hazard , Lender of Last Resort , bank size , loss function , prompt LOLR action , LOLR record , CB response , LOLR support exercise , Commercial banks , Open market operations , Distressed institutions

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Summary

This paper develops a model of the lender of last resort. It provides an analytical basis for “too big too fail” and a rationale for “constructive ambiguity”. Key results are that if contagion (moral hazard) is the main concern, the Central Bank (CB) will have an excessive (little) incentive to rescue banks and the resulting equilibrium risk level is high (low). When both contagion and moral hazard are jointly analyzed, the CB’s incentives to rescue are only slightly weaker than with contagion alone. The CB’s optimal policy may be non-monotonic in bank size.