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Coordination failures and the lender of last resort: was Bagehot right after all

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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 ar efficient, a solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot's view. The authors's theory does not rely on the multiplicity of equilibria that arises in classicalmodels of bank runs. Rochet and Vives 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. They 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.

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en

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application/pdf

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http://flora.insead.edu/fichiersti_wp/inseadwp2002/2002-24.pdf

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Copyright INSEAD. All rights reserved