Lender of Last Resort and Bank Closure Policy

Abstract

AbstractDuring the last 20 years a consensus has emerged that it is impossible to disentangle liquidity shocks from solvency shocks. As a consequence, the classical lender of last resort (LOLR) rules, as defined by Thornton and Bagehot and which is based on lending to solvent illiquid institutions, appears ill-suited to this environment. We summarize here the main contributions that that consider this new paradigm and discuss how institutional features relating to bank closure policy influences lender of last resort and other safety net issues. We devote particular emphasis to the analysis of systemic risk and contagion in banking and the role of the lender of last resort to prevent it. We argue that the financial crisis that began in 2007 redefines the functions of the lender of last resort of the twenty-first century placing it at the intersection of monetary policy, fiscal policy, supervision, and regulation of the banking industry, and the organization of the interbank market.