Chapter 16: Lender of Last Resort & Reserve Strategies (Sections 16.1, 16.3, 16.4) Flashcards
(8 cards)
What key trade-off do banks face when deciding how much liquid reserves to hold?
Reserves (cash or Treasuries) insure a bank against unexpected withdrawals but earn low returns. Holding more reserves reduces the danger of a liquidity crunch but cuts into interest income.
How does a Lender of Last Resort (LLR) alter banks’ reserve decisions in the Martin model?
With an LLR backstop—emergency loans to solvent banks at penalty rates—banks feel safer and hold smaller reserves, since they can tap central-bank funding in a crisis.
Real-world parallel: during 2008, many U.S. banks relied on the Fed’s discount window rather than carry large reserves.
What unintended side-effect can an LLR create on banks’ liquidity buffers?
If the central bank lends too readily, banks may hoard almost no reserves, becoming vulnerable to small, idiosyncratic shocks that the LLR will not cover.
In the Ratnovski model, why might banks choose lower reserves even when they expect only selective bailouts?
The LLR in this model intervenes only if both banks need help—and then only rescues one. Anticipating that ‘if I fail and my peer fails I might be rescued,’ each bank optimally cuts reserves.
Can you give a real-world example of selective bailouts shaping bank behavior?
During the euro-area crisis, ECB liquidity assistance was contingent on collateral quality and bank size—smaller banks held more reserves, larger ones presumed ECB support.
How did private bank coalitions act as de facto LLRs before modern central banks?
In 19th-century U.S., clearing houses pooled resources: if a member faced a panic, others lent it liquidity or liquidated weak members, issuing ‘loan certificates.’
Why did these coalitions allow banks to hold lower reserves than standalone institutions?
By agreeing to liquidate failing members and redistribute payoffs to survivors, the coalition signaled strength to depositors—each bank benefited from collective credibility.
What lesson does the Gorton–Huang coalition teach about modern LLR design?
Effective backstops—public or private—depend on credible, enforceable commitments to share liquidity and losses. Without credible rules, banks revert to self-insurance via high reserves.
