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Coordination failures and the lender of last resort: was Bagehot right after all?

By Jean-Charles Rochet and Xavier Vives

Abstract

The classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), asserts that the Central Bank should lend to “illiquid but solvent” banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are e¢cient, a solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot’s view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We build a model of banks’ liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot …nd liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure policy of the Central Bank

Topics: HG Finance, HB Economic Theory
Publisher: Financial Markets Group, London School of Economics and Political Science
Year: 2002
OAI identifier: oai:eprints.lse.ac.uk:24928
Provided by: LSE Research Online

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