Discussion Paper Details

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Title: Complementing Bagehot: Illiquidity and insolvency resolution

Author(s): Sylvester C W Eijffinger and Rob Nijskens

Publication Date: October 2011

Keyword(s): Bailout, Bank Regulation, Capital, Lender of Last Resort and Liquidity

Programme Area(s): International Macroeconomics

Abstract: During the recent financial crisis, central banks have provided liquidity and governments have set up rescue programmes to restore confidence and stability, often against the LLR principle advocated by Bagehot. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and monitors too little. A central bank can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce an additional authority that is able to bail out the bank either by injecting capital at a fixed return or by receiving an equity claim. This authority faces a trade-off: demanding a fixed premium increases investment but worsens moral hazard. Request for an equity claim by the fiscal authority reduces excessive risk taking at the expense of investment. This resembles the current situation on financial markets, in which banks take less risk but also provide less credit to the economy

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Bibliographic Reference

Eijffinger, S and Nijskens, R. 2011. 'Complementing Bagehot: Illiquidity and insolvency resolution'. London, Centre for Economic Policy Research.