Emergency liquidity provision to public banks: Rules versus discretion

•We analyze the incentives to provide liquidity to a distressed public bank.•We show that discretionary liquidity provision does not lead to a first best outcome.•We show that optimal rules exist inducing first best behavior.

This paper analyzes a government's incentives to provide financial assistance to a public bank which is hit by a liquidity shock. We show that discretionary decisions about emergency liquidity assistance result in either excessively small or excessively large liquidity injections in a wide variety of circumstances. Also, adding a lender of last resort does not generally ensure a socially optimal policy. However, optimal rules exist that align the preferences of the government and/or a lender of last resort with social preferences by either subsidizing or taxing liquidity aid.