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The LOLR Policy and its Signaling Effect in a Time of Crisis

Author

Listed:
  • Mei Li

    (University of Guelph)

  • Frank Milne

    (Queen’s University)

  • Junfeng Qiu

    (Central University of Finance and Economics)

Abstract

When a government implements an LOLR policy during a crisis, creditors can infer a bank’s quality by whether the bank borrows government loans. We establish a formal model to study an LOLR policy in the presence of this signaling effect. We find that three equilibria exist: a separating equilibrium where only low quality banks borrow from the government and two pooling equilibria where both high and low quality banks do and do not borrow from the government. Further, we find that the government’s lending rate serves an important signaling role and that hiding the identity of the banks that borrow government loans tends to encourage banks to do so. We also find two welfare effects of the LOLR policy: the liquidation cost saving and moral hazard. Depending on which effect dominates, the optimal LOLR policy differs.

Suggested Citation

  • Mei Li & Frank Milne & Junfeng Qiu, 2020. "The LOLR Policy and its Signaling Effect in a Time of Crisis," Journal of Financial Services Research, Springer;Western Finance Association, vol. 57(3), pages 231-252, June.
  • Handle: RePEc:kap:jfsres:v:57:y:2020:i:3:d:10.1007_s10693-019-00324-6
    DOI: 10.1007/s10693-019-00324-6
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    References listed on IDEAS

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    Cited by:

    1. Mei Li & Frank Milne & Junfeng Qiu, 2022. "Central bank screening, moral hazard, and the lender of last resort policy," Journal of Banking Regulation, Palgrave Macmillan, vol. 23(3), pages 244-264, September.
    2. Huberto M. Ennis & Elizabeth C. Klee, 2021. "The Fed's Discount Window in "Normal" Times," Finance and Economics Discussion Series 2021-016, Board of Governors of the Federal Reserve System (U.S.).

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    Keywords

    Signaling; Lender of last resort;

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