Central Bank Screening, Moral Hazard, and the Lender of Last Resort Policy

Mei Li, Frank Milne and Junfeng Qiu ()

No 1506, Working Papers from University of Guelph, Department of Economics and Finance

Abstract: This paper establishes a theoretical model to examine the LOLR policy when a central bank can distinguish solvent banks from insolvent ones only imperfectly. The major results that our model produces are as follows: (1) The pooling equilibria in which, on one hand, all the banks borrow from the central bank and, on the other hand, all the banks do not borrow from the central bank could exist given certain market beliefs off the equilibrium path. However, neither equilibrium is socially efficient because insolvent banks will continue to hold their unproductive assets, rather than efficiently liquidating them. (2) Higher precision in central bank screening will improve social welfare not only by identifying insolvent banks and forcing them to efficiently liquidate their assets, but also by reducing moral hazard and deterring banks from choosing risky assets in the first place. (3) If a central bank can commit to a specific precision level before the banks choose their assets, rather than conducting a discretionary LOLR policy, it will choose a higher precision level to reduce moral hazard and will attain higher social welfare.

Keywords: Central Bank Screening; Moral Hazard; Lender of Last Resort (search for similar items in EconPapers)
JEL-codes: E58 G20 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2015
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cta, nep-mac and nep-mon
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Related works:
Journal Article: Central bank screening, moral hazard, and the lender of last resort policy (2022)
Working Paper: Central Bank Screening, Moral Hazard, And The Lender Of Last Resort Policy (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:gue:guelph:2015-06

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