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The LOLR Policy and its Signaling Effect in a Time of Crisis

  • Mei LiEmail author
  • Frank Milne
  • Junfeng Qiu
Article
  • 35 Downloads

Abstract

When a government implements an LOLR policy during a crisis, creditors can infer a bank’s quality by whether the bank borrows government loans. We establish a formal model to study an LOLR policy in the presence of this signaling effect. We find that three equilibria exist: a separating equilibrium where only low quality banks borrow from the government and two pooling equilibria where both high and low quality banks do and do not borrow from the government. Further, we find that the government’s lending rate serves an important signaling role and that hiding the identity of the banks that borrow government loans tends to encourage banks to do so. We also find two welfare effects of the LOLR policy: the liquidation cost saving and moral hazard. Depending on which effect dominates, the optimal LOLR policy differs.

Keywords

Signaling Lender of last resort 

JEL Classifications

E58 G28 

Notes

Acknowledgments

We greatly thank the editor and two anonymous referees for their helpful comments.

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Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2019

Authors and Affiliations

  1. 1.Department of Economics and Finance, Gordon S. Lang School of Business and EconomicsUniversity of GuelphGuelphCanada
  2. 2.Department of EconomicsQueen’s UniversityKingstonCanada
  3. 3.China Economics and Management AcademyCentral University of Finance and EconomicsBeijingChina

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