Who Should Act as Lender of Last Resort? An Incomplete Contracts Model

This paper presents a model of a bank subject to liquidity shocks that require borrowing from a lender of last resort. Two government agencies may perform this function: a central bank and a deposit insurance corporation. The agencies share supervisory information, which provides a nonverifiable signal of the bank's financial condition, and use it to decide whether to support it. It is shown that the optimal institutional design involves the two agencies: the central bank dealing with small liquidity shocks, and the deposit insurance corporation with large shocks. Furthermore, except for very small shocks, they should lend at penalty rates