Optimal bail out policy, conditionality and creative ambiguity

Freixas, Xavier (1999) Optimal bail out policy, conditionality and creative ambiguity. Financial Markets Group Discussion Papers (327). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

This paper addresses the issue of the optimal behaviour of the Lender of Last Resort (LOLR) in its microeconomic role regarding individual financial institutions in distress. It has been argued that the LOLR should not intervene at the microeconomic level and let any defaulting institution face the market discipline, as it will be confronted with the consequences of the risks it has taken. By considering a simple cost benefit analysis we show that this position may lack a sufficient foundation. We establish that, instead, under reasonable assumptions, the optimal policy has to be conditional on the amount of uninsured debt by the defaulting bank. Yet in equilibrium, because the rescue policy is costly, the LOLR will not rescue all the banks that fulfill the uninsured debt requirement condition, but will follow a mixed strategy This we interpret as the confirmation of the "creative ambiguity" principle, perfectly in line with the central bankers claim that it is efficient for them to have discretion in lending to individual institutions. Alternatively, in other cases, when the social cost of a bank's bankruptcy is too high, it is optimal for the LOLR to bail out of the institution, and this gives support to the "too big to fail" policy.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 1999 The Author
Divisions:	Financial Markets Group
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G10 - General G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies
Date Deposited:	04 Jul 2023 13:27
Last Modified:	14 Sep 2024 04:33
URI:	http://eprints.lse.ac.uk/id/eprint/119121

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