Turning Bagehot on his head

Lending at penalty rates when banks can become insolvent

F. Castiglionesi, W.B. Wagner

Research output: Contribution to journalArticleScientificpeer-review

Abstract

Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wisdom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insolvency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios.
Original languageEnglish
Pages (from-to)201-219
JournalJournal of Money, Credit and Banking
Volume44
Issue number1
Publication statusPublished - 2012

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Penalty
Lending
Incentives
Moral hazard
Pioneering
Scenarios
Lender of last resort
Prescription
Insolvency
Wisdom

Cite this

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Turning Bagehot on his head : Lending at penalty rates when banks can become insolvent. / Castiglionesi, F.; Wagner, W.B.

In: Journal of Money, Credit and Banking, Vol. 44, No. 1, 2012, p. 201-219.

Research output: Contribution to journalArticleScientificpeer-review

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