Systemic Risk, Interbank Market Contagion, and the Lender of Last Resort Function

We develop a theoretical model examining the financial stability policy of a central bank serving as both the lender of last resort and the regulator of the financial system. Our model accommodates the possibility of financial contagion through interbank market linkages, and adverse feedback from the financial system to the real economy. We identify the volume of activity in the interbank money market, the relative riskiness of the agents in the financial system, and the probability of systemic distress as the key factors influencing the design of financial stability policy. Furthermore, results of simulating the model indicate that there is a substitution effect between reducing the expected scope of a central bank’s assistance to an institution in distress and increasing bank capital requirements.