Establishing Monetary Control in Financial Systems with Insolvent Institutions

Abstract

The paper addresses the problem of establishing monetary control in financial systems with insolvent institutions. In particular, it examines the potential adverse selection, moral hazard, and collusion problems that can arise if indirect, auction-based monetary control systems are used in this environment. The analysis also considers the credit risks that can be assumed by the authorities when these market failures occur. The implications of using several alternative monetary control mechanisms, including a narrow banking system, the use of credit ceilings, and a two-tier banking system, are also examined.