Discussion Paper Details

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Title: Liquidity, Risk-Taking and the Lender of Last Resort

Author(s): Rafael Repullo

Publication Date: March 2005

Keyword(s): bank supervision, capital requirements, central bank, deposit insurance, lender of last resort, moral hazard and penalty rates

Programme Area(s): Financial Economics

Abstract: This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn, and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank?s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement, and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of a LLR. Thus, in contrast with the general view, the existence of a LLR does not increase the incentives to take risk, while penalty rates do.

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Bibliographic Reference

Repullo, R. 2005. 'Liquidity, Risk-Taking and the Lender of Last Resort'. London, Centre for Economic Policy Research.