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So obviously, given these additional costs a policy of individual liquidity assistance is only preferable if the welfare gains of this LOLR-policy outweighs these costs. But as we have already argued the gains of an individual liquidity assistance diﬀer with respect to the ﬁnancial system under consideration. Thus, in a bank-dominated ﬁnancial system in which the eﬃciency gains of an individual liquidity assistance are relatively large in moderate as well as in severe liquidity crises it is rather likely that a LOLR prefers to bear the additional information costs in order to be able to pursue this LOLR-policy. In contrast, in market-oriented ﬁnancial systems, where the drawback of market interventions is in both types of ﬁnancial crises less severe, the LOLR may decide to save the costs of acquiring the required information for an individual liquidity assistance and use market interventions to provide the banking system with additional liquidity.
Proposition 7 Taking into account, that there are more cost intense information requirements associated with an individual liquidity assistance, a LOLR-policy based on We assume that the LOLR cannot observe the region the bank is located in. Thus, the regions should not be taken literally but can be interpreted as sectors of the economy which are inﬂicted in diﬀerent for outsiders not easily observable ways by the macroeconomic shock.
individual liquidity assistance may be preferable in bank-based ﬁnancial system but not in market-oriented ﬁnancial systems.
6 Conclusions In this paper on liquidity crises and lender of last resort policies we can distinguish between three diﬀerent types of crisis situations. In a slight liquidity crisis there is no need for a lender of last resort. No banks are subject to a run, the only thing we observe is a slight increase of interest rates. In contrast, a moderate liquidity crisis is characterized by runs on weak banks. Depositors seize assets and late projects will be restructured. Finally, in a severe liquidity crisis not only runs on weak banks can be observed but also strong banks will be liquidity rationed and have to partially restructure their late projects. Accordingly, in a moderate and in a severe liquidity crisis the intervention of a lender of last resort may be preferable to prevent runs from occurring.
However, from our main results we can draw a connection between ﬁnancial system conﬁgurations and the optimal lender of last resort policy, i.e. a market intervention following Bagehots’ rules and lending liquidity freely at penalty rates, or an individual liquidity assistance provided discretionary by the lender of last resort.
In a moderate as well as in a severe liquidity crisis individual liquidity assistance guarantees a more eﬃcient allocation of the provided liquidity. However, in both crisis situations the welfare losses due to the ineﬃcient waste of liquidity are higher in bankdominated ﬁnancial systems than in market-oriented ﬁnancial systems. Thus, taking into account the more costly informational requirements of a lender of last resort that follows a policy of an individual liquidity assistance it may follow that the information costs outweigh the eﬃciency gain from a individual liquidity assistance in a marketoriented but not in a bank-oriented ﬁnancial system.
Presumably, this argument in favor of a market intervention in market-oriented ﬁnancial systems can further be strengthened: By incorporating into the analysis that a market intervention proportionally wastes more liquidity in the moderate than in the severe liquidity crises, we get lower eﬃciency loss from market intervention in a severe liquidity crisis if the informational costs of the LOLR increase with the amount of liquidity provided on an individual basis. Having in mind that, as we showed in Proposition 3, under reasonable assumption a market-oriented system is more often in a severe than in a moderate liquidity crisis, this also implies lower eﬃciency losses of a market intervention in a market-oriented system.
Of course, there are important qualiﬁcations to this conclusion. Our model is incomplete in at least three aspects, which we want to analyze in future research.
First of all we have to determine endogenously the decision of a lender of last resort to examine and inspect the banks who seek liquidity support in diﬀerent ﬁnancial systems.
Secondly, in future work we want to elaborate on the ex ante decision of a bank about investing in projects and in storage technology. Thirdly and may be most important, our model is quiet about possible moral hazard behavior of banks induced by a lender of last resort. The only thing we can say for sure is that in our framework banks in bank-dominated systems acquire higher rents than banks in a market-oriented system, since the activity of the former are more ﬁrm-speciﬁc. Of course, these diﬀerences aﬀect their behavior. In which direction the behavior will be inﬂuenced, that would be a very interesting and important topic of the LOLR policy analysis in the context of diﬀerent ﬁnancial systems.
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