Overcoming Borrowing Stigma: The Design of Lending-of-Last-Resort Policies

How should the government effectively provide liquidity to banks during periods of financial distress? During the 2008-2010 crisis, banks avoided borrowing from the Fed's long-standing discount window (DW), but actively borrowed and sometimes paid a higher interest in its special monetary program, the Term Auction Facility (TAF), although both programs had the same borrowing requirements. We use a dynamic adverse selection model with endogenous borrowing stigma costs to explain how the combination of the DW and TAF increased banks' borrowing and willingness to pay for loans from the Fed. Using micro-level data on DW borrowing and TAF bidding from 2007 to 2010, we confirm our theoretical predictions about the financial condition of banks in different facilities.