Research Discussion Papers, Bank of Finland
No 1/2001:
An assessment of alternative lender of last resort schemes
Risto Herrala ()
Abstract: We sketch a theoretical framework for comparing the
properties of funded LOLR schemes. We construct an idealized lender of last
resort and investigate how it formulates policy under alternative public
and private governance structures. The alternatives are a (first-best)
social utility maximizer that can dictate participation, and three
voluntary schemes: a public lender of last resort, a mutual clearing house
that formulates policy by voting, and a profit maximizing private LOLR
scheme. We compare the policies formulated by these institutions from the
viewpoint of social desirability. Our model targets the debate on free
banking, in particular the issue of whether private institutions would fare
well as lenders of last resort.
In our model, the first-best LOLR
scheme always covers the whole banking sector and offers full insurance to
the participants. We find that voluntary schemes succeed relatively well as
lenders of last resort in situations where recipients of LOLR assistance
can repay LOLR loans with interest. In this case, the LOLR can use interest
rate policy to make the scheme attractive to banks of every quality and
thus create incentives for comprehensive entry. In private schemes, policy
tends to be distorted if the private scheme is the only possible scheme.
However, competitive forces lead private institutions to approach the
first-best outcome, which is the only contestable outcome.
The end
result changes when we investigate a situation in which banks’ ability to
repay LOLR loans is limited. When lending is associated with losses for the
LOLR, good quality banks will tend to stay out of the LOLR scheme and
participation in voluntary schemes will always fall short of the first-best
outcome. A compulsory scheme (such as a central bank that can impose a
reserve requirement on banks) has an advantage over voluntary schemes.
Keywords: liquidity; lender of last resort; banking; central banking; governance; (follow links to similar papers)
JEL-Codes: E58; G21; (follow links to similar papers)
31 pages, February 12, 2001
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