According to the classic studies by Thornton and Bagehot, the lender of last resort should provide emergency assistance directly to troubled banks, with the qualification that lending should be done at high rates, against good collateral, and only to solvent institutions. Some twenty years ago, an alternative to this “banking” view has emerged in particular through contributions by Goodfriend and King, Bordo, Kaufman, and Schwartz.
These contributions are sometimes usefully aggregated into the so-called “monetary” view, which says that once the financial system has obtained sufficient liquidity through an equitable open market operation, interbank markets for short-term credit should be sufficiently efficient to warrant the availability of liquidity for any bank that deserves it. The two opposing views on the management of financial distress have provoked a fruitful theoretical debate about the role and identity of the lender of last resort in contemporary banking regulation.
One recent strand of the literature that has received particular attention by supporting the banking view is concerned with the conditions under which the working of the interbank market can be relied upon even during a crisis situation. Flannery has argued that the problem of adverse selection may make the screening of loan applicants more difficult for banks in times of market distress. Rochet and Vives identify a potential coordination problem when lenders in the secondary market are heterogeneously informed.
In their framework, the unique equilibrium may have the feature that with positive probability, there is no market assistance for the troubled bank. Finally, Freixas, Parigi, and Rochet consider a double moral hazard problem involving the tasks of screening loan applicants and monitoring ongoing credit relationships. There, the lender of last resort has a role if and only if missing incentives for screening are the main source of moral hazard.
As an additional “banking” argument for why targeted lending may be superior to open market operations, the present paper considers speculative motives by commercial banks and their affiliated securities houses. Indeed, as we argue, with asset prices being depressed during the crisis, liquidity is attractive not only for commercial banks in trouble but also for commercial banks that seek to exploit the liquidity shock. However, an open market operation at the conditions of the current monetary stance is unable to discriminate between banks that are in trouble and those that are not, and thereby makes these groups of banks compete for liquidity. The effect is that some of the troubled banks will have to liquidate their balance sheets, while speculators might gain. To the extent that such liquidations are not socially desirable, the effect will make targeted liquidity assistance more appropriate than an open market operation in our framework.
The rest of this paper is structured as follows. Section 2 outlines the formal framework, and describes the equilibrium in the financial market. Section 3 considers three policy alternatives, emergency lending, open market operation, and outright intervention in the asset market, and investigates the impact of these policies on the trade-off between market efficiency and central bank exposure. Section 4 offers extensions and discusses the robustness of our findings. The conclusions are collected in Section 5. Appendix A gives a formal account of the equilibrium concept. Proofs have been relegated to Appendix B.
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