Abstract
In a framework closely related to Diamond and Rajan (J Polit Econ 109:287–327, 2011) we characterize different financial systems and analyze the welfare implications of different central bank policies in these financial systems. We show that in case of a large negative liquidity shock, liquidity demand has lower interest rate elasticity in a bank-based financial system than in a market oriented financial system. Market interventions, i.e. non-standard monetary policy measures to inject liquidity need to be much larger in a bank-based financial system in order to bring down interest rates to sustainable levels. Therefore, in financial systems with rather illiquid assets an individual liquidity assistance might be welfare improving, while in market oriented financial systems, with rather liquid assets in the banks’ balance sheets, liquidity assistance provided freely to the market at a penalty rate is likely to be efficient. While the costs of individual support might not be worthwhile in a market oriented financial system in which deadweight losses of market based support are small, in a bank based system the deadweight losses of unconventional monetary policy are large and thus individual support more efficient.
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Notes
- 1.
- 2.
See for instance Fecht et al. (2015).
- 3.
For a discussion of the different lender of last resort function(s), see Freixas et al. (1999). We do not want to touch the issue if there should (and could) be an institutional separation between a central bank which is responsible for the conduct of monetary policy and a lender of last resort; on this topic see Goodhart (1995). Also we do not analyze the potential agency conflicts between deposit insurance fund, central bank and bank supervisors; on this see Repullo (2000) and Kahn and Santos (2005).
- 4.
See Allen and Gale (2004) for a survey.
- 5.
Of course, we maintain the relation γC > 1 > c 1 for a market-based system. Only the difference is small.
- 6.
- 7.
See Schmidt and Tyrell (2005) for a discussion how these two perspectives on information, i.e. externalization and internalization, can be mapped into two approaches to the role of information in financial systems, namely the rational expectations literature on the role of prices in resource allocation and the intermediation literature which is concerned with the role of banks as delegated monitors. See in addition Fecht (2004) where using a Diamond/Dybvig framework the stability of different financial systems is analyzed. Within that framework, distinct financial systems are characterized by the fraction of households with direct investment opportunities that are less efficient than those available to banks. If the fraction with inferior direct investment opportunities is relatively high, the financial system will be called a bank-dominated one, in the other case characterized by a high fraction of households with “efficient” direct access to investment opportunities, the financial system is market-oriented. Note that such a characterization of financial systems is complementary to the one given in the paper here.
- 8.
We assume a court system, which can enforce financial contracts and transfer assets to lenders when contracted repayments are defaulted upon, but cannot compel entrepreneurs or bankers to contribute their human capital. Thus the court can help to seize the project’s assets or the bank’s loans, respectively. However, the value of these assets depends on the cash flow the lenders can generate out of the assets.
- 9.
Acquiring the specific collection skills to enforce repayment on the part of an entrepreneur is a costly activity which is not worth doing by a small investor in analogy to arguments given in Diamond (1984).
- 10.
See Diamond and Rajan (2001) for a full analysis of this mechanism.
- 11.
This requirement is either exogenously imposed by regulators or endogenously determined as a result of—in our case unmodelled—uncertainty along the line of Diamond and Rajan (2000).
- 12.
As in Allen and Gale (2000b) we assign a nearly zero probability at date 0 to the occurrence of the negative shock. We perturb the model in this way in order to have no change in the allocation decision of the bank at date 0. Alternatively, Diamond and Rajan (2005) show that even with nonnegligible probability of an adverse shock the bank will lend all the funds they raise in case the expected return from lending is higher than the storage return. Thus, we could also assume a nonzero probability for the macroeconomic shock. It would not change the main results of our analysis.
- 13.
The bank manager will continue the project despite having a strong preference for date 1 consumption. This means that even with a high discount rate of date 2 consumption the present value of the rent she can earn is positive.
- 14.
Strictly speaking, our usage of the term interest rate is a bit loose. To be precise, r = 1 + i with i as the interest rate in the liquidity market. Note, that we take as given that banks do not store but invest any funds in lending activity. Clearly, this is the optimal decision when the probability p 1 for the state where all the projects in both regions are early, is sufficiently high.
- 15.
Note that we assumed \(\tilde{r}\) always being below the interest rate level at which the strong bank cannot raise enough liquidity to repay deposits: \(\hat{r} <\tilde{ r} <\hat{\hat{ r}}\).
- 16.
For a more detailed discussion of this argument see Allen and Gale (1998).
- 17.
Remember that we assumed a discount rate for these agents that always exceeds the equilibrium interest rate. Therefore: \(\rho>\tilde{ r}\).
- 18.
Note that this argument assumes that the LOLR cannot observe the region the bank is located in. Thus, the regions cannot be taken literally but can be interpreted as sectors of the economy which are inflicted in different for outsiders not easily observable ways by the macroeconomic shock.
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Acknowledgements
We would like to thank Jean-Charles Rochet, Elena Carletti, Jan Pieter Krahnen, Gerhard Illing and the participants of the CFS Summer School, of the conference on “Banking, Financial Stability and the Business Cycle” at the Sveriges Riksbank, of seminars at the Federal Reserve Bank of Kansas City, the Deutsche Bundesbank, the European Central Bank, the Goethe University Frankfurt, the EEA Meeting and the 60th birthday conference in Honor of Gerhard Illing for stimulating discussions and helpful comments.
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Fecht, F., Tyrell, M. (2017). Optimal Lender of Last Resort Policy in Different Financial Systems. In: Heinemann, F., Klüh, U., Watzka, S. (eds) Monetary Policy, Financial Crises, and the Macroeconomy. Springer, Cham. https://doi.org/10.1007/978-3-319-56261-2_3
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