2005) Liquidity, Risk Taking, and the Lender of Last Resort

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory informa-tion on the quality of the bank’s assets.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 equi-librium 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 an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do. JEL Codes: E58, G21, G28. From their inception, central banks have assumed as one of their key responsibilities the provision of liquidity to banks unable to find it elsewhere. The classical doctrine on the lender of last resort (LLR) was put forward by Bagehot (1873, 96–7): “Nothing, therefore, can be more certain than that the Bank of England... must in time of panic do what all other similar banks must do.... And for this purpose there are two rules: First. That these loans should only be made at a very high rate of interest.... Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. ” The contemporary lit-erature on the LLR has disagreed on whether the aim of “stayin