Lender of last resort and the moral hazard problem

Mikko Niskanen
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Mikko Niskanen: Opstock Ltd. , Helsinki Finland

Macroeconomics from EconWPA

Abstract: The paper considers a modelin which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

Keywords: central bank; liquidity provision; lender of last resort; moral hazard (search for similar items in EconPapers)
JEL-codes: E5 G0 G2 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn and nep-reg
Date: 2004-05-14
Note: Type of Document - pdf
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpma:0405016

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