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Borrowing Stigma and Lender of Last Resort Policies
Published online by Cambridge University Press: 16 October 2023
Abstract
How should the lender of last resort provide liquidity to banks during periods of financial distress? During the 2008–2010 crisis, banks avoided borrowing from the Fed’s long-standing discount window but actively participated in its special monetary program, the Term Auction Facility, although both programs had the same borrowing requirements. Using an adverse selection model with endogenous borrowing decisions, we explain why the two programs suffer from different stigma costs and how the introduction of TAF incentivized banks’ borrowing. We discuss the empirical relevance of the model’s predictions.
[Banks] deliberately did not ask for the liquidity they needed for fear of damaging their reputation—the ‘stigma’ problem… I do not think we were conscious of this before the crisis started and I do not think central banks have a convincing answer to it… This is, I think, still a challenge in how to manage the process of central bank provision of liquidity support. This is one of the big intellectual issues that has not been fully resolved. (Governor Mervyn King, Bank of England (2016))
For various reasons, including the competitive format of the auctions, [Term Auction Facility] has not suffered the stigma of conventional discount window lending and has proved effective for injecting liquidity into the financial system… Another possible reason that [Term Auction Facility] has not suffered from stigma is that auctions are not settled for several days, which signals to the market that auction participants do not face an immediate shortage of funds. (Ben Bernanke, testimony to U.S. House of Representatives (2010))
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- © The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington
Footnotes
We are grateful for comments and suggestions from an anonymous referee, Viral Acharya, Sriya Anbil, Olivier Armantier, Yasser Boualam, Chen Cheng, Jason Roderick Donaldson, Huberto Ennis, Paolo Fulghieri, Gary Gorton, Robin Greenwood, Anil Kashyap, Vijay Krishna, Aeimit Lakdawala, Raoul Minetti, Paige Ouimet, George Pennacchi (the editor), Jacob Sagi, Philipp Schnabl, David Thesmar, Larry Wall, Yiqing Xing, and participants at UNC Kenan-Flagler, JHU Carey, MSU economics, 2018 Doug Diamond’s birthday conference, 2019 EFA, 2019 Northeastern Finance Conference, 2019 FIRS, University of Wisconsin, 2019 Stony Brook Game Theory Festival, 2019 Yale Fighting a Financial Crisis Conference, the Chicago Fed, the Richmond Fed, Boston University, the Atlanta Fed, 2020 Midwest Macro Conference, 2019 AEA Conference, 2020 MFA Conference, 2020 Short-Term Funding Markets Conference, and 2020Australian National Finance Conference. We also thank Nathan Delaney, Nancy Gahlot, Sunwoo Hwang, Peiyi Jin, Dongming Yu, and especially Spencer Andrews for their research assistance. Zhang acknowledges the National Science Foundation.
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