Zombification and Central Bank Risk-Taking: The Lender of Last Resort as a Signal Extraction Problem

Ulrich Bindseil () and Juliusz Jablecki ()
Additional contact information
Ulrich Bindseil: YPFS, Yale School of Management, https://elischolar.library.yale.edu/journal-of-financial-crises/
Juliusz Jablecki: YPFS, Yale School of Management, https://elischolar.library.yale.edu/journal-of-financial-crises/

Journal of Financial Crises, 2023, vol. 5, issue 3, 1-22

Abstract: In the liquidity crises since 2008, central banks have extended the ability of banks to take recourse to central bank credit operations through changes of the collateral framework. Remarkably, in March 2020, the European Central Bank (ECB) even lowered haircuts across a broad range of assets, and the Federal Reserve in March 2023 established a credit facility with securities accepted at par (without any haircut). Although such measures aim at stabilizing the banking system, some observers have warned that they would increase central bank risk exposure, encourage moral hazard, and ultimately lead to inefficiencies, as wasteful enterprises and "zombie" firms are kept afloat. We provide a simple four-sector model of the economy that illustrates the key trade-offs inherent in central banks' responses to liquidity crises. Specifically, we derive central bank lender-of-last-resort (LOLR) policies as optimal from the perspective of a signal extraction problem, in which liquidity needs of banks toward the central bank are noisy signals of underlying firms' performance. LOLR policies thus need to balance costs of default of illiquid but viable firms against the costs of letting unproductive zombie firms continue to operate. We explain why in a financial crisis, in which liquidity shocks become more erratic, central banks allow for greater potential recourse of banks to central bank credit. The model also shows the endogeneity of counterparty and issuer risks to the central bank's collateral and related risk-control framework. Finally, the model allows identifying the circumstances under which the counterintuitive case arises in which a relaxation of the central bank collateral policy may reduce its expected losses while also supporting growth.

Keywords: central bank; collateral policy; economic growth; LOLR; risk-taking; zombification (search for similar items in EconPapers)
JEL-codes: G01 G28 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://elischolar.library.yale.edu/cgi/viewconten ... -of-financial-crises (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ysm:ypfsfc:v:5:y:2023:i:3:p:1-22

Access Statistics for this article

More articles in Journal of Financial Crises from Yale Program on Financial Stability (YPFS) Contact information at EDIRC.
Bibliographic data for series maintained by ().