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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