by Spyros Pagratis
Bank of England
This paper considers a model of information-based bank runs where a central bank sets its lender of last resort (LOLR) policy in order to maximize welfare. To mitigate the risks associated with overinvestment by the banking sector, the central bank sets prudential liquidity requirements for the banking sector in the form of a ratio of liquid assets to deposits. Liquidity requirements then provide a buffer against early deposit withdrawals, but they also allow the central bank to manufacture a distribution of costs to LOLR funding with an expected value equal to 0. It is shown that liquidity requirements, along with an appropriate LOLR policy, become welfare improving if the banking sector is characterized by high-profit opportunities, low leverage, and a relatively volatile deposit base. Otherwise, forgone productive investment due to liquidity restrictions may result in a disproportional cost to the banking sector relative to the insurance value of LOLR.
JEL Codes: E58, G28.
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