№ 9/2017

Fìnansi Ukr. 2017 (9): 29–52

MONETARY POLICY

KOZIUK Viktor ¹

¹West Ukrainian National University
OrcID ID : https://orcid.org/0000-0002-5715-2983

Last resort lending and weak institutions: a view from the position of game theory

The global financial crisis showed how vulnerable lender-of-last-resort function may be. Central banks went beyond classical Bagehot (1873) principles generating additional claims for transparency, consistency and prudence in their LOLR behavior. But weak institutions case should be taken as some doubts about possibilities of LOLR to improve the situation as first best. The paper formulates a hypothesis that weak institutions activate additional space for misbehavior among banks and the central bank and that deepening crisis and game theory may help understand the ways of how gamers’ behavior generates different modalities of macro-financial instability. It is shown that almost all lender-of-last-resort features, shaped during the global financial crisis, are under strong distortions by weak institutions. Related lending, oligarchical banking, shifting risks to outsiders, capital drain as well as additional demand on safe assets are structural features of weal institution economy. At the same time, such features constitute the logic of potential strategic behavior of the central bank and banks in different informational asymmetry sets. It is proved that game theory approach reflects better features of strategic behavior of the central bank and banks during the crisis. Comparison of game scenarios that the central bank is an active lender of last resort and that it avoids active liquidity provision during the first game step shows worse trade-off. The variant “first best” is viable in the first case but it is not feasible with weak institutions. The variant “second best” is achieved under the second scenario but the path to it is longer and brings with it additional shock. Information asymmetry about banking system conditions as well as probability of banks opportunistic behavior are the key factors that restrain central bank possibility to choose socially optimal game strategy. However, it is hard to predict which strategy is beneficial because lack of efficient ranging of different crisis modalities may misguide the central bank. It means that the regulator is always in a worse situation and may behave intuitively rather than consistently. At the same time, a more probable demand on save assets during crisis, a higher level of dollarization, stronger engagement in related lending, capital drain should be taken into account as motivators for less relaxed LOLR. The experience of Ukraine supports this view.

Keywords:central bank, lender of last resort, opportunistic behavior, weak institutions, game theory

JEL: E02, E44, E58

KOZIUK V. . Last resort lending and weak institutions: a view from the position of game theory / V. . KOZIUK // Фінанси України. - 2017. - № 9. - C. 29-52.

Article original in Ukrainian (pp. 29 - 52)

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