Emergency liquidity provision to public banks: Rules versus discretion |
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Institution: | 1. Heinrich-Heine-University Düsseldorf, Department of Economics, Universitätsstraße 1, 40225 Düsseldorf, Germany;2. University of Portsmouth, United Kingdom;3. University of Leipzig, Department of Economics, Grimmaische Straße 12, 04109 Leipzig, Germany |
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Abstract: | This paper analyzes a government's incentives to provide financial assistance to a public bank which is hit by a liquidity shock. We show that discretionary decisions about emergency liquidity assistance result in either excessively small or excessively large liquidity injections in a wide variety of circumstances. Also, adding a lender of last resort does not generally ensure a socially optimal policy. However, optimal rules exist that align the preferences of the government and/or a lender of last resort with social preferences by either subsidizing or taxing liquidity aid. |
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