Optimal lender of last resort policy in different financial systems

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.