The Role of Liquidity Standards in Optimal Lending of Last Resort Policies

We consider a model in which banks vulnerable to liquidity crises may receive support from the lender of last resort (LLR). Higher liquidity standards, though costly to banks, give the LLR more time to find out the systemic implications of denying support to the banks in trouble. By modifying banks' prospects of being supported in a crisis, liquidity standards affect banks' adoption of precautions against a crisis. We show that this effect is positive (negative) when banks are ex ante perceived to be systemically important (unimportant). We analyze the implications of these results for the design of liquidity standards and LLR policies