Policy uncertainty, lender of last resort and the real economy

• Published in: Journal of monetary economics 2021-03, Vol.118, p.381-398
• Main Authors: Jasova, Martina, Mendicino, Caterina, Supera, Dominik
• Format: Article
• Language: English
• Subjects: Bank credit; Central bank commitment; Real effects
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2020.12.001

•We assess the lending and real effects of a reduction in lender of last resort (LOLR) policy uncertainty, while previous literature examines uncertainty related to other policies.•In the absence of a long-horizon commitment to the availability of LOLR funding, the introduction of long-term operations reduces uncertainty regarding banks’ ability to satisfy their funding needsth and stimulates lending and real outcomes only if provided at favourable conditions relative to the private market funding.•We show that the real option channel is also important for banks A reduction in lender of last resort (LOLR) policy uncertainty positively affects bank lending and propagates to investment and employment. We exploit a unique policy that reduced uncertainty regarding the availability of future LOLR funding for banks as a quasi-natural experiment. Using micro-level data on banks, firms and loans in Portugal, we generate cross-sectional variation in banks’ exposure to uncertainty and find that the size of the haircut subsidy - the gap between private market and central bank security valuations - plays a key role in the propagation of the shock to lending and the real economy.