Liquidity provision, ambiguous asset returns and the financial crisis

Spanjers, Willem (2011) Liquidity provision, ambiguous asset returns and the financial crisis. (Working Paper) Freiburg, Germany : University of Freiburg. 40 p. (RCEA Working Papers, no. 11-10)

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In a setting similar to Allen and Gale (1998), the optimal liquidity provision is analyzed for illiquid assets subjected to incalculable risk (i.e. ambiguity). We consider the ex-ante second best liquidity allocation, an ad interim asset market, and a competitive banking sector. If investors know imminent banking panics trigger appropriate regulatory intervention, a competitive banking sector implements the second best outcome. Ambiguity leads to dynamic inconsistency in investor behaviour. If banks mis-interpret the ambiguity, unanticipated fundamental bank runs may occur, which they incorrectly blame on investors 'loosing their nerves' and 'panicing'. The fundamental mechanism of the financial crisis resembles a banking panic in the presence of ambiguous asset returns. The combination of providing additional liquidity and supporting distressed banks effectively implements the regulatory policy suggested for the model. A credible commitment to such 'bail-out-policy' does not create a moral hazard problem. Rather, is 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.

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