Working Paper: CEPR ID: DP3233
Authors: Jean-Charles Rochet; Xavier Vives
Abstract: The classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), asserts that the Central Bank should lend to ?illiquid but solvent? banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are efficient, a solvent bank cannot be illiquid. This Paper provides a possible theoretical foundation for rescuing Bagehot?s view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We build a model of banks? liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure policy of the Central Bank.
Keywords: Central bank policy; Global games; Interbank market; Liquidity ratio; Orderly failure resolution; Prompt corrective action; Prudential regulation; Solvency ratio; Supermodular games; Transparency
JEL Codes: G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high liquidity ratio (G33) | eliminate coordination failures (P11) |
| eliminate coordination failures (P11) | only insolvent banks fail (G33) |
| high liquidity ratio (G33) | solvent banks remain operational (G21) |
| low liquidity ratio (G33) | solvent banks become illiquid (G33) |
| lender of last resort policy (E58) | resolve coordination failures (D74) |
| high precision of private signals (C58) | decrease probability of failure (G22) |
| optimal disclosure (D82) | stabilize financial system (G28) |