Liquidity provision, ambiguous asset returns and the financial crisis

Spanjers, Willem (2018) Liquidity provision, ambiguous asset returns and the financial crisis. Review of Economic Analysis, 10(4), pp. 371-407. ISSN (online) 1973-3909

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Abstract

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 ambiguity, 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.

Item Type: Article
Research Area: Economics and econometrics
Faculty, School or Research Centre: Faculty of Arts and Social Sciences (until 2017) > School of Economics, History and Politics (from November 2012)
Depositing User: Susan Miles
Date Deposited: 23 Aug 2017 07:57
Last Modified: 19 Dec 2018 15:12
URI: http://eprints.kingston.ac.uk/id/eprint/38730

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