A sheep in wolf's clothing: Can a central bank appear tougher than it is?

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Abstract

Central banks (CBs) in Europe and the US have been providing virtually unlimited amounts of liquidity to banks for quite some time now. This may lead banks to expect that these CBs will be lenient in the future. Will this expectation be justified? I present a model in which a commercial bank, subject to idiosyncratic liquidity shocks, faces uncertainty about whether the CB is tough (Hawk) or lenient (Dove). Specifically, the CB knows its nature, but the bank does not. When uncertainty is high, the CB can use this to its advantage and try to build a reputation for toughness. In response, the bank chooses higher liquidity reserves in equilibrium. Furthermore, increasing bank capital and penalty rates make it easier to build a reputation, while bailouts by the fiscal government make it more difficult.
Original languageEnglish
Pages (from-to)94-103
JournalJournal of Banking & Finance
Volume48
DOIs
Publication statusPublished - Nov 2014
Externally publishedYes

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Keywords

  • banking
  • liquidity
  • regulation
  • ambiguity
  • reputation

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