Coordination Failures And The Lender Of Last Resort: Was Bagehot Right After All?: (Revision 1)
The classical doctrine of the Lender of Last Resort, elaborated by Bagehot (1873), asserts that the central bank should lend to "illiquid but solvent" banks under certain conditions. Several authors have argued that this view is now obsolete: when interbank markets are efficient. A solvent bank cannot be illiquid. This paper provides a possible theoretical foundation for rescuing Bagehot's view. The theory does not rely on the multiplicity of equilibria that arises in classical models of bank runs. The authors build a model of banks' liquidity crises that possesses a unique Bayesian equilibrium.