In this paper I ask whether a central bank policy of providing liquidity to banks during panics can prevent bank runs without causing moral hazard. This kind of policy has been widely advocated, most notably by Bagehot (1873). I show a particular central bank liquidity provision policy can prevent bank panics without moral hazard problems. A key feature of this policy is that the central bank has priority over the assets of the banks it lends to, if they default. I also show that a deposit insurance policy, while preventing runs, can create moral hazard problems.

Keywords: Bank Panics; Liquidity Provision; Deposit Insurance; Moral Hazard.

JEL classification: E58; G21.

Antoine Martin is an economist at the Federal Reserve Bank of Kansas City. The author would like to thank V.V. Chari for his support and suggestions. He would also like to thank John Boyd, Russell Cooper, Joe Haslag, Kevin Huang, Larry Jones, Narayana Kocherlakota, Thor Koeppl, Cyril Monnet, Marguerite Oneto, Warren Weber, and workshop participants at the University of Minnesota, Iowa State University, University of Western Ontario, and the Swiss National Bank for helpful comments. The author would like to thank Brooke Vance for editorial assistance. All remaining errors belong to the author. The views expressed are the author’s and do not necessarily reflect those of the Federal Reserve Bank of Kansas City, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System.

Martin E-mail: antoine.martin@kc.frb.org