Limited Commitment and Central Bank Lending

Abstract

Central bank or International Monetary Fund lending should be regarded as a line of credit, analogous to private line-of-credit products. Contractual provisions in private line-of-credit arrangements are designed to control managerial moral hazard and provide a means for profit-maximizing lenders to credibly commit to withdraw credit and induce closure when appropriate. The contractual mechanisms utilized by private line-ofcredit providers are not effective for a central bank whose primary mission-to maintain financial system stability-can override its obligation to protect public funds and undercut its ability to limit its lending reach. We consider in some detail five broad approaches to a central bank's commitment problem: good offices only, collateralization and early intervention, constructive ambiguity, extending supervisory and regulatory reach, and reputation building. Our analysis suggests that the first four institutional approaches cannot be counted on to overcome the fundamental forces inducing a central bank to lend. We argue that the only practical way for a central bank to credibly limit lending is for it to build up over time a reputation for restraint.

Models of Discount Window Lending: A Review

“…Rochet and Vives discuss many of the factors not present in the model that would suggest that a penalty rate may be appropriate -for example, if the central bank has better information relative to the private sector, but not perfect information. There is also a discussion of the possibility that the private sector could provide lines of credit to banks and then actively monitor them (as suggested by Goodfriend and Lacker [1999]). The authors point out that this could be an appropriate approach when there are no central-bank advantages in supervisory knowledge and …nancial capacity.…”

Interventions in Markets with Adverse Selection: Implications for Discount Window Stigma

“…However, in practical terms, seniority of claims is much less clear-cut when taking a consolidated-government perspective in the presence of deposit insurance. While discount window loans are fully collateralized, it is often the case that the losses experienced by the insurance fund depend on the ability of the failing bank to borrow from the discount window before failing (Goodfriend and Lacker (1999)). The extra liquidity available to the bank through the discount window is often used to pay back uninsured depositors, making them effectively senior claimants relative to the consolidated government.…”

Should There Be Intraday Money Markets?

“…Lack of commitment by the central bank One factor that may make it difficult for an intraday money market to function efficiently is a commitment problem on the part of the central bank. As noted by Goodfriend and Lacker (1999), commitment is an important problem for central banks. Now consider the central bank's commitment problem were it to rely on an intraday market to distribute funds.…”