Paper #708

Title:

The lender of last resort: A 21st Century approach

Authors:

Xavier Freixas, Bruno M. Parigi and Jean-Charles Rochet

Date:

September 2003

Abstract:

The object of this paper is to analyze rigorously the role of a Lender of Last Resort by providing a framework where the distinction between insolvency and illiquidity is not clearly cut. Determining the optimal Lender of Last Resort policy requires a careful modeling of the structure of the interbank market and of the closure policy. In our set up, the results depend upon the existence of moral hazard. If the main source of moral hazard is the banks’ lack of incentives to screen loans, then the Lender of Last Resort may have to intervene to improve the e¢ciency of an unsecured interbank market; if instead, the main source of moral hazard is loans monitoring, then the interbank market should be secured and the Lender of Last Resort should never intervene.

Keywords:

Lender of Last Resort, interbank market, liquidity

JEL codes:

G21, G28

Area of Research:

Finance and Accounting

Published in:

Journal of the European Economic Association, Vol 2(6) Dec 2004

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