Complementing Bagehot: Illiquidity and insolvency resolution

Sylvester Eijffinger and Rob Nijskens

No 8603, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: During the recent financial crisis, central banks have provided liquidity and governments have set up rescue programmes to restore confidence and stability, often against the LLR principle advocated by Bagehot. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and monitors too little. A central bank can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce an additional authority that is able to bail out the bank either by injecting capital at a fixed return or by receiving an equity claim. This authority faces a trade-off: demanding a fixed premium increases investment but worsens moral hazard. Request for an equity claim by the fiscal authority reduces excessive risk taking at the expense of investment. This resembles the current situation on financial markets, in which banks take less risk but also provide less credit to the economy

Keywords: Bailout; Bank regulation; Capital; Lender of last resort; Liquidity (search for similar items in EconPapers)
JEL-codes: E58 G21 G28 (search for similar items in EconPapers)
Date: 2011-10
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cis, nep-mac, nep-mon and nep-reg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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