Working Paper: CEPR ID: DP7674
Authors: Rob Nijskens; Sylvester C.W. Eijffinger
Abstract: Banking regulation has proven to be inadequate to guard systemic stability in the recent financial crisis. Central banks have provided liquidity and ministries of finance have set up rescue programmes to restore confidence and stability. Using a model of a systemic bank suffering from liquidity shocks, we find that the unregulated bank keeps too much liquidity and takes excessive risk compared to the social optimum. A Lender of Last Resort can alleviate the liquidity problem, but induces moral hazard. Therefore, we introduce a fiscal authority that is able to bail out the bank by injecting capital. This authority faces a trade-off: when it imposes strict bailout conditions, investment increases but moral hazard ensues. Milder bailout conditions reduce 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.
Keywords: bailout; bank regulation; capital; lender of last resort; liquidity
JEL Codes: E58; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lender of last resort reduces excessive liquidity hoarding (E51) | Moral hazard leads banks to take excessive risks (G21) |
| Introduction of fiscal authority with strict bailout conditions (E63) | Increased investment levels (E22) |
| Milder bailout conditions (H81) | Reduced excessive risk-taking (G41) |
| Milder bailout conditions (H81) | Lower investment (G31) |
| Regulatory environment influences banks' risk and investment strategies (G28) | Causal relationship between regulatory frameworks and bank behavior in crisis situations (G28) |