Money Market Discipline and Central Bank Lending

Abstract

This paper provides a theory for the joint existence of lending on decentralized money markets (secured or unsecured) and lending by a central bank. There is endogenous adverse selection in the sense that banks choose the quality of their investments, which is private information. When banks need to refinance their investments, the bargaining solution on the unsecured money market eliminates excessive risk-taking, at the cost of terminating some investments that would have been continued under full information. The secured market eliminates excessive risk-taking by forcing borrowers to pledge collateral, at the cost of reducing the scale of productive investments. When there is aggregate liquidity risk, we show that the joint existence of money markets (be it secured or unsecured) and central bank lending improves upon money markets alone. However, without aggregate risk, central bank lending can only make matters worse by reducing market discipline.