Research Discussion Papers, Bank of Finland
No 3/2000:
Markets, Reserves and Lenders of Last Resort as Sources of Bank Liquidity
Risto Herrala ()
Abstract: We study the long standing issue of whether markets can
supply banks with sufficient liquidity or whether markets should be
complemented with a lender of last resort (LOLR). For this purpose, we
develop an extended version of the recent model of Holmström and Tirole
(1998) on the supply of liquidity to firms. H&Ts original model analyses
liquidity supply to firms that are facing solvency shocks. We apply their
framework to banking and extend the framework to admit the analysis of
problems associated with transitory liquidity outflows, even absent any
change in a bank's value. Our premise is that the scope for moral hazard
may increase in connection with liquidity outflows. Moral hazard, which we
interpret as the possibility of laxity in banks' monitoring of firms, may
increase with liquidity outflows because banks need to increase their
monitoring efforts in order to safeguard their own interests.
The model
illustrates many key aspects the classical LOLR debate. The model shows how
moral hazard limits of banks’ ability to borrow from markets to cover
liquidity outflows. It also predicts banks’ demand for liquid reserves and
the economies associated with centralization of reserves in a liquidity
pool when the holding of liquid reserves entails opportunity costs.
Finally, the model enables discussion of viable lending policies for the
LOLR and contrasts these with the ‘Bagehotian principles’, which are still
widely used as benchmark criteria in evaluating LOLR operations.
Keywords: liquidity; lender of last resort; banking; central banking; (follow links to similar papers)
JEL-Codes: E58; G21; (follow links to similar papers)
27 pages, April 18, 2000
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