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Liquidity, Risk-Taking, and the Lender of Last Resort

By Rafael Repullo


(Preliminary and incomplete) This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn, and a lender of last resort (LLR) that bases its intervention decision on supervisory information on the quality of the bank’s assets. The bank, which is subject to a capital requirement, chooses the liquidity bu¤er that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement, and increasing in the interest rate charged by the LLR. Moreover, the risk chosen without penalty rates is the same as in the absence of a LLR. Thus, in contrast with the general view, the existence of a LLR does not increase the bank’s incentives to take risk, while penalty rates do

Topics: JEL Classi…cation, E58, G21, G28
Year: 2003
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