Liquidity, Risk Taking, and the Lender of Last Resort

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.