A Model of the Lender of Last Resort

Haizhou Huang and C. Goodhart

No 1999/039, IMF Working Papers from International Monetary Fund

Abstract: This paper develops a model of the lender of last resort. It provides an analytical basis for “too big too fail” and a rationale for “constructive ambiguity”. Key results are that if contagion (moral hazard) is the main concern, the Central Bank (CB) will have an excessive (little) incentive to rescue banks and the resulting equilibrium risk level is high (low). When both contagion and moral hazard are jointly analyzed, the CB’s incentives to rescue are only slightly weaker than with contagion alone. The CB’s optimal policy may be non-monotonic in bank size.

Keywords: WP; central bank; Banking Crises; Financial Contagion; Moral Hazard; Lender of Last Resort; bank size; loss function; prompt LOLR action; LOLR record; CB response; LOLR support exercise; Commercial banks; Open market operations; Distressed institutions (search for similar items in EconPapers)
Pages: 33
Date: 1999-03-01
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Citations: View citations in EconPapers (73)

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