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

Authors :
Frank Milne
Mei Li
Junfeng Qiu
Source :
Journal of Financial Services Research. 57:231-252
Publication Year :
2019
Publisher :
Springer Science and Business Media LLC, 2019.

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.

Details

ISSN :
15730735 and 09208550
Volume :
57
Database :
OpenAIRE
Journal :
Journal of Financial Services Research
Accession number :
edsair.doi...........e9c4503c6b52ea8ccac055a6a8e07f64
Full Text :
https://doi.org/10.1007/s10693-019-00324-6