FABIO CASTIGLIONESI WOLF WAGNER Turning Bagehot on His Head: Lending at Penalty Rates When Banks Can Become Insolvent Ever since Bagehot’s (1873) pioneering work, it is a widely accepted wis- dom that in order to alleviate (ex ante) bank moral hazard, a lender of last resort should lend at penalty rates only. In a model in which banks are subject to shocks but can exert effort to affect the likelihood of these shocks, we show that the validity of this argument crucially relies on banks always remaining solvent. The reason is that when banks become insolvent, Bagehot’s prescription dictates to let them fail. Penalty rates charged when banks are illiquid (but solvent) then reduce banks’ incentives to avoid insol- vency ex ante and thus increase bank moral hazard. We derive a condition which shows precisely when this effect on ex ante incentives outweighs the traditional one and show that it is fulfilled under plausible scenarios. JEL codes: E58, G21, G28 Keywords: Bagehot, lender of last resort, penalty rates, moral hazard. THE CONCEPT OF THE LENDER of last resort (LLR) has its origins in the beginning of the nineteenth century and was initiated by the work of Thornton (1802). Successively, Bagehot (1873) refined and advanced its analysis. Bagehot is credited nowadays with establishing the modern LLR theory. 1 This theory can be summarized by the so-called Bagehot principle: lend freely against good collateral at a high interest rate. In particular, Bagehot argued that the role of the LLR in a liquidity crisis is to lend to illiquid but solvent financial institutions, that is, institutions with good collateral. We thank the Editor (Robert DeYoung), Fabio Feriozzi, Bert Willems, and two anonymous referees for useful comments. Castiglionesi acknowledges financial support from the Marie Curie Intra European Fellowship. The usual disclaimer applies. FABIO CASTIGLIONESI is an Associate Professor, European Banking Center, CentER, Department of Finance, Tilburg University (E-mail: fabio.castiglionesi@uvt.nl). WOLF WAGNER is a Professor, European Banking Center, TILEC, Center, Department of Economics, Tilburg University (E-mail: wagner@uvt.nl). Received December 29, 2009; and accepted in revised form June 15, 2011. 1. The term “LLR” in fact owes its origin to Sir Francis Baring. In 1797, he referred in his Observations on the Establishment of the Bank of England to the Central Bank as the “dernier resort from which all banks could obtain liquidity in times of crisis” (Humphrey and Keleher 1984). Journal of Money, Credit and Banking, Vol. 44, No. 1 (February 2012) C  2012 The Ohio State University