Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 17/2002:
Lender of last resort and the moral hazard problem

Mikko Niskanen

Abstract: The paper considers a model in which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

Keywords: central bank; liquidity provision; lender of last resort; moral hazard; (follow links to similar papers)

JEL-Codes: E50; G00; G20; (follow links to similar papers)

36 pages, July 10, 2002

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