Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?

By Jean-Charles Rochet, Xavier Vives. 2002

836 citations recorded by the source corpus.

The classical doctrine of the Lender of Last Resort, elaborated by Thornton (1802) and Bagehot (1873), asserts that the Central Bank should lend to 'illiquid but solvent' banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are efficient, a solvent bank cannot be illiquid. This Paper provides a possible theoretical foundation for rescuing Bagehot's view. Our theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. We build a model of banks' liquidity crises that possesses a unique Bayesian equilibrium. In this equilibrium, there is a positive probability that a solvent bank cannot find liquidity assistance in the market. We derive policy implications about banking regulation (solvency and liquidity ratios) and interventions of the Lender of Last Resort as well as on the disclosure policy of the Central Bank.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/ff419f857fb74b399f07b73f221d356b8e034fd7

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Citations in the corpus

A Pigovian Approach to Liquidity Regulation (2011, background): “(3) Notice that the short-term funding decision x of any bank of class θ determines, via ε(x, θ), the vulnerability of that very bank to a systemic crisis, and also, via c(X), the likelihood and/or costs of a systemic crisis to all other banks.”
Complementarities and Games: New Developments (2005, background): “The second application is an instance of coordination failure in the interbank market proving a rationale for a Lender of Last Resort intervention ( Rochet and Vives (2002) ).”
Transparency in the Financial System: Rollover Risk and Crises (2014, neutral): “Rochet and Vives (2004) show that public information may have destabilizing effects because it reinforces coordination concerns, which generates multiple self-fulfilling equilibria.”
Double Bank Runs and Liquidity Risk Management (2016, positive): “fundamentals, which is consistent with the theoretical literature that focuses on runs based on bank fundamentals (Rochet and Vives, 2004; Goldstein and Pauzner, 2005; Allen, Carletti, Goldstein and Leonello, 2013).”
Self-Fulfilling Credit Market Freezes (2011, background): “These include the papers by Rochet and Vives (2004), Corsetti, Guimaraes, and Roubini (2006), and Morris and Shin (2006).”
The Three Pillars of Basel II, Optimizing the Mix (2004, background): “Rochet and Vives (2002) for a recent account of this doctrine).”
Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (2013, neutral): “52 In Rochet and Vives (2004), individual information is noisy and aggregate information is not, but the withdrawal mechanism is ill suited to provide for an efficient use of the aggregate information.”
Strategic Complementarities and the Twin Crises (2005, neutral): “Alternative specifications, where banks might fail also in the short term, are offered by Goldstein and Pauzner (2005) and by Rochet and Vives (2004), and follow Diamond and Dybvig (1983).”
Bailouts and Financial Fragility (2016, positive): “15 Stein (2013) also discusses the distinction between price-based and quantity-based regulation in the context of the new liquidity regulations.”