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Der Open-Access-Publikationsserver der ZBW – Leibniz-Informationszentrum Wirtschaft

The Open Access Publication Server of the ZBW – Leibniz Information Centre for Economics

Fecht, Falko; Tyrell, Marcel

Working Paper

Optimal lender of last resort policy in

different financial systems

Discussion paper Series 1 / Volkswirtschaftliches Forschungszentrum der Deutschen

Bundesbank, No. 2004,39

Provided in cooperation with:

Deutsche Bundesbank, Forschungszentrum Suggested citation: Fecht, Falko; Tyrell, Marcel (2004) : Optimal lender of last resort policy in different financial systems, Discussion paper Series 1 / Volkswirtschaftliches Forschungszentrum der Deutschen Bundesbank, No. 2004,39, http:// hdl.handle.net/10419/19506

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zbw Leibniz-Informationszentrum Wirtschaft Leibniz Information Centre for Economics Optimal lender of last resort policy in different financial systems Falko Fecht (Deutsche Bundesbank) Marcel Tyrell (University of Frankfurt and Trier) Discussion Paper Series 1: Studies of the Economic Research Centre No 39/2004 Discussion Papers represent the authors’ personal opinions and do not necessarily reflect the views of the Deutsche Bundesbank or its staff.

Heinz Herrmann

Editorial Board:

Thilo Liebig Karl-Heinz Tödter Deutsche Bundesbank, Wilhelm-Epstein-Strasse 14, 60431 Frankfurt am Main, Postfach 10 06 02, 60006 Frankfurt am Main Tel +49 69 9566-1 Telex within Germany 41227, telex from abroad 414431, fax +49 69 5601071 Please address all orders in writing to: Deutsche Bundesbank, Press and Public Relations Division, at the above address or via fax No +49 69 9566-3077 Reproduction permitted only if source is stated.

ISBN 3–86558–034–3

Abstract:

In a framework closely related to Diamond and Rajan (2001) we characterize different financial systems and analyze the welfare implications of different LOLR-policies in these financial systems. We show that in a bank-dominated financial system it is less likely that a LOLR-policy that follows the Bagehot rules is preferable. In financial systems with rather illiquid assets a discretionary individual liquidity assistance might be welfare improving, while in market-based financial systems, with rather liquid assets in the banks’ balance sheets, emergency liquidity assistance provided freely to the market at a penalty rate is likely to be efficient. Thus, a ”one size fits all”-approach that does not take the differences of financial systems into account is misguiding.

Keywords: Financial Crises, Lender of Last Resort, Comparing Financial Systems

JEL Classification: D52, E44, E52, E58, G21 Non technical summary In this paper, we take a first step to investigate which form of liquidity assistance to banks a lender of last resort should follow given the type of financial system the banks are embedded. Nowadays it is well proven fact that even with regard to industrialized countries financial systems differ in many dimensions. As a consequence, a classification of financial systems in market-based or bank-based financial system emerged. However, we focus our analysis on one aspect, namely the importance of relationship lending in market-oriented and bank-dominated financial systems. Our starting point is that strong relations between firms and banks are more predominant in bank-based financial systems.

First, we develop a taxonomy of crises situations, namely slight, moderate or severe liquidity crises, whereas the occurrence of a certain crisis situation depends on the magnitude of the negative macroeconomic shock that causes an aggregate liquidity shortage. In addition, we argue that the importance of relationship lending has an influence on the occurrence of crises situations as well. Market-based financial systems end up more often in light and severe liquidity crises while in bank-based financial systems moderate liquidity crises are more likely. The higher marketability of loans in market-based systems on the one hand is more efficient in buffering small aggregate shocks, but on the other hand it gives stronger incentives to investors to liquidate their stakes in the banks in case of a big shock.

In the second part we analyze the welfare implications of different lender of last resort-policies in these crises situations. We consider two alternatives, i.e. discretionary individual liquidity assistance to illiquid banks and market interventions provided along the rules of Bagehot. In comparing both policies, it can be shown that the relative welfare gains of individual liquidity assistance are higher particularly in moderate liquidity crises. Providing assistance by market interventions leads to a waste of liquidity since part of it ends up in liquid banks. This waste of liquidity is the more severe the more illiquid bank loans are. However, individual liquidity assistance is associated with more cost intense information requirements. Taking higher information costs of an individual liquidity assistance into account, we come to the conclusion that individual liquidity assistance may be preferable in bank-dominated financial systems but not in market-oriented financial systems where market interventions might be more appropriate. Of course, there are some qualification to this conclusion. Most important, our model is quiet about possible moral hazard behavior of banks induced by the lender of last resort-policy. This aspect will be analyzed in future research.





Nicht technische Zusammenfassung Im Rahmen einer modelltheoretischen Analyse gehen wir der Frage nach, inwieweit es notwendig ist, die Ausgestaltung der nationalen Lender of Last Resort-Politik an dem in einem Land vorherrschenden Finanzsystemtypus auszurichten. Ausgangspunkt unserer Analyse ist die inzwischen wissenschaftlich etablierte These, dass sich die Strukturen der Finanzsysteme industrialisierter L¨nder stark voneinander unterscheiden, wobei a sich eine Klassifikation in bankdominierte oder kapitalmarktorientierte Finanzsysteme durchgesetzt hat. Diese Unterscheidung bilden wir in unserem Modellrahmen in der Weise ab, dass Hausbankbeziehungen eine je nach Finanzsystemtyp unterschiedlich große Bedeutung zukommt: Bankdominierte Finanzsysteme sind st¨rker durch diese a Art der Finanzierungsbeziehung gepr¨gt als kapitalmarktorientierte Systeme.

a Zun¨chst charakterisieren wir unterschiedliche Typen von Finanzkrisen (schwere, a moderate und leichte), die je nach Ausmaß des makro¨konomischen Liquidit¨tsschocks o a auftreten. Sie unterscheiden sich darin, inwieweit aufgrund des Liquidit¨tsengpasses a Finanzierungsbeziehungen vorzeitig abgebrochen werden und/oder es zu Bankenzusammenbr¨chen kommt. Wir zeigen auf, dass es in durch enge Hausbankbeziehungen u gekennzeichneten Finanzsystemen h¨ufiger zu moderaten Liquidit¨tskrisen kommt, a a w¨hrend in kapitalmarktorientierten Finanzsystemen Schocks eher in schwache oder a starke Liquidit¨tskrisen m¨nden. Die h¨here Marktf¨higkeit der vergebenen Kredite a u o a in kapitalmarktorientierten Finanzsystemen kann kleinere makro¨konomische Schocks o zwar besser abpuffern, f¨hrt jedoch bei großen Schocks zu einer h¨heren Krisenanf¨lligu o a keit der Banken, da Anleger einen st¨rkeren Liquidationsanreiz haben.

a Im zweiten Schritt untersuchen wir dann, welche Form der Liquidit¨tsbereitstellung a durch eine Zentralbank in den jeweiligen Krisenszenarien effizienter ist. Wir zeigen, dass insbesondere in moderaten Krisen eine individuelle Liquidit¨tsbereitstellung an a illiquide Banken vorzuziehen ist. Der Grund hierf¨r liegt darin, dass eine Marktinu tervention keine zielgenaue Liquidit¨tsbereitstellung an illiquide Banken erlaubt. Sie a bringt eine ”ineffiziente Liquidit¨tsverschwendung” mit sich, die umso gr¨ßer ist, je a o illiquider Bankkredite sind. Allerdings geht die individuelle Unterst¨tzung mit h¨heren u o Informationserfordernissen f¨r die Zentralbank einher. Bei nicht zu hohen Informau tionskosten kommen wir somit zu dem Gesamtergebnis, dass in bankdominierten Finanzsystemen eine Lender of Last Resort-Politik im Sinne einer individuellen Liquidit¨tsbereitstellung eher angebracht ist, w¨hrend in kapitalmarktorientierten Finanza a systemen eine Marktintervention entlang der Regeln von Bagehot vorzuziehen ist.

Unsere Ergebnisse ber¨cksichtigen dabei allerdings nicht, in welcher Weise die unteru schiedlichen Formen der Liquidit¨tsbereitstellung moral hazard auf Seiten der Banken a hervorrufen. Diesen Aspekt wollen wir in einem weiteren Forschungsprojekt integrieren.

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–  –  –

1 Introduction

In the last two decades financial crises, a phenomenon that most observers in the 1970’s thought to be a relict of the past, has reawakened the interest of academics and practitioners. Following the collapse of the Bretton Woods agreement in 1973 and the subsequent wave of deregulation in many countries, financial crises reemerged. For instance, Lindgren and Saal (1996) found that about three quarter of the IMF’s member countries suffered some form of banking crises, though panics in the traditional sense were avoided either by central bank interventions or by explicit or implicit government guarantees. The experience with crises in Scandinavian countries like Norway, Finland and Sweden in the 1980’s and more recently in East-Asian and Latin-American countries shows that crises were particularly disruptive in terms of the depth of ensuing recessions. This explains why the question of how to prevent or handle financial crises is one of the most lively debated policy and research issues in the financial community.

In this debate, largely unanimity prevails that the maintenance of financial stability is facilitated by well-designed ”safety net” arrangements aimed at both limiting the risk of disruption in the financial system (crisis prevention) and the consequences of disruption if it arises (crisis management). A central element of these arrangements is the lender of last resort. There is considerable agreement on the need of a lender of last resort to provide emergency liquidity assistance in reaction to an adverse shock which causes an abnormal increase in demand for liquidity that cannot be met from an alternative source. Usually this role of a lender of last resort (LOLR) is assigned to the central bank.1 ∗ We would like to thank Jean-Charles Rochet, Elena Carletti, and the participants of the CFS Summer School 2002, of the conference on ”Banking, Financial Stability and the Business Cycle” at the Sveriges Riksbank 2004, of the seminar at the Federal Reserve Bank of Kansas City 2004, of the seminar at the Deutsche Bundesbank 2004, and of the European Economic Association Meeting in Madrid 2004 for stimulating discussions and very helpful comments. The views expressed herein are those of the authors and not those of the Deutsche Bundesbank.

See for a discussion of the lender of last resort function(s) Freixas, X. et al. (November 1999). We do not want to touch the issue if there should (and could) be an institutional separation between a central bank which is responsible for the conduct of monetary policy and a lender of last resort; on this topic see Goodhart (1995). Also we do not analyze the potential agency conflicts between deposit insurance fund, central bank and bank supervisors; on this see Repullo (2000) and Kahn and Santos (2001).



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