Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis

Willem Spanjers
2018 Review of Economic Analysis  
For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector offering deposit contracts. In a setting related to Allen and Gale (JoF, 1998) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns.In the context of our model, ambiguity -- i.e. incalculable risk -- leads to dynamically inconsistent investor behaviour. If the financial sector fails to recognize the presence of
more » ... ty, unanticipated fundamental crises may occur, which are incorrectly blamed on investors 'loosing their nerves' and 'panicing'.The basic mechanism of the Financial Crisis resembles the liquidation of illiquid assets during a banking panic. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model.A credible commitment to such 'bail-out policy' does not create a moral hazard problem. Rather, it implements the second best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability -- as suggested by ordo-liberalism and the 'Freiburger Schule' -- enhances ex-ante welfare.
doi:10.15353/rea.v10i4.1475 fatcat:hmiavzic2fflfgdtap3d3ndtmy