THE LENDER OF LAST RESORT: A TWENTY-FIRST CENTURY APPROACH

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 t...

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Bibliographic Details
Published in:Journal of the European Economic Association 2004-12, Vol.2 (6), p.1085-1115
Main Authors: Freixas, Xavier, Rochet, Jean-Charles, Parigi, Bruno M.
Format: Article
Language:English
Subjects:
Bank assets
Bank liquidity
Bank loans
Bank markets
Bankers
Banking industry
Banking regulation
Capital
Central banks
Financial economics
Liquidity
Loans
Resurrection
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Summary: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.
ISSN:1542-4766
1542-4774
DOI:10.1162/1542476042813841