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Lender of last resort and the moral hazard problem

Author

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  • Mikko Niskanen

    (Opstock Ltd. , Helsinki Finland)

Abstract

The paper considers a modelin which limited liability causes an asset substitution problem for banks. The problem can at times become so severe that the current regulatory framework – based on a combination of effectively full deposit insurance, minimum capital requirements and prudential supervision – proves inadequate for mitigating the moral hazard. Against this background, consideration is given to the question of how, and at what cost, an increase in market discipline would improve incentives. Finally, the additional microeconomic incentive effects of lender of last resort (LOLR) arrangements in the various alternatives is discussed. In conclusion, it is argued that LOLR arrangements in which the terms of liquidity support depend on the bank’s risk profile can be effective in improving the bank’s incentives to make the desired risk choice in the first place.

Suggested Citation

  • Mikko Niskanen, 2004. "Lender of last resort and the moral hazard problem," Macroeconomics 0405016, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpma:0405016
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    References listed on IDEAS

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    16. Bill B. Francis & Iftekhar Hasan & Delroy M. Hunter, 2004. "Return-volatility linkages in the international equity and currency markets," Finance 0405022, University Library of Munich, Germany.
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    Cited by:

    1. Cecile Bastidon & Philippe Gilles & Nicolas Huchet, 2008. "A Selective Bail-Out International Lending of Last Resort Model," Annals of Economics and Finance, Society for AEF, vol. 9(1), pages 103-114, May.

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    More about this item

    Keywords

    central bank; liquidity provision; lender of last resort; moral hazard;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G0 - Financial Economics - - General
    • G2 - Financial Economics - - Financial Institutions and Services

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