Systemic Risk, Interbank Market Contagion, and the Lender of Last Resort Function

Abstract

We develop a theoretical model examining the financial stability policy of a central bank serving as both the lender of last resort and the regulator of the financial system. Our model accommodates the possibility of financial contagion through interbank market linkages, and adverse feedback from the financial system to the real economy. We identify the relative riskiness of the agents in the financial system, the probability of systemic distress, and the expected duration of credit supply reduction as the key factors influencing the design of financial stability policy. Results of model simulations indicate the existence of a substitution effect between reducing the expected scope of a central bank's assistance to an institution in distress and increasing bank reserve requirements.