A Model of the Lender of Last Resort

Abstract

This paper develops a model of the lender of last resort (LOLR). In a simple one-period setting, the Central Bank (CB) should only rescue banks which are above a threshold size, thus providing an analytical basis for ¶too big to fail¶. In a dynamic setting, the CBs optimal LOLR policy is time varying and contingent on the probabilities and effects of failure and of the likelihood of a bank requiring LOLR being insolvent. If contagion is the main concern, then the CB in general would have an excessive incentive to rescue especially large banks. If moral hazard is the main concern, the CB in general would have little incentive to rescue banks. When both contagion and moral hazard are jointly analyzed, then the CBs incentive to rescue are stronger than in the single period setting, but weaker than in the dynamic setting with contagion alone.