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Abstract:
The paper models the links between financial fragility, asset markets and monetary policy. It is shown that central bank's concern about the cost of financial disruption generates an asymmetric response, thus contributing to the creation of an asset price bubble. In an economy with a highly leveraged financial structure, the central bank has an incentive to prevent a "run" on financial intermediation by injecting liquidity when asset values fall significantly. The inflationary side effect of this policy reduces the real value of nominal debt and so gives rise to a "put option" for investors, driving up asset prices above their fundamental value. The paper shows that the size of such a bubble is likely to be rather small. The bubble is only equal to the expected value of capital gains on outstanding debt, which are fairly limited in a crisis. Since, in contrast, the gains from preventing the disruption of financial intermediation can be quite large, it is rational for a central bank to inject liquidity in a crisis.

Asset Bubbles, Monetary Policy, Financial Stability

Abstract:
The paper models the links between financial fragility, asset markets and monetary policy. It is shown that central bank's concern about the cost of financial disruption generates an asymmetric response, thus contributing to the creation of an asset price bubble. In an economy with a highly leveraged financial structure, the central bank has an incentive to prevent a "run" on financial intermediation by injecting liquidity when asset values fall significantly. The inflationary side effect of this policy, reducing the real value of nominal debt, is what gives rise to a "put option" for investors. Leveraged investors, rationally anticipating this liquidity injection, drive asset prices above their fundamental values. The paper shows, however, that the size of such a bubble is likely to be rather small. The bubble is only equal to the expected value of capital gains on outstanding debt, which are fairly limited in a crisis. Since, in contrast, the gains from preventing the disruption of financial intermediation can be quite large, it is rational for a central bank to inject liquidity in a crisis.

Abstract:
The paper presents a stylised framework to analyse conditions under which monetary policy contributes to amplified movements in the housing market. Extending work by Hyun Shin (2005), the paper analyses self enforcing feedback mechanisms resulting in amplifier effects in a credit constrained economy. The paper characterizes conditions for asymmetric effects, causing systemic crises. By injecting liquidity, monetary policy can prevent a meltdown. Anticipating such a response, private agents are encouraged to take higher risks. Provision of liquidity works as a public good, but it may create potential conflicts with other policy objectives and may give incentives to build up leverage with a high systemic exposure to small probability events.

Abstract:
The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we consider a model with pure illiquidity risk, it turns out that such a policy will encourage banks to behave naughty, providing insufficient level of liquidity.

monetary policy, liquidity risk, financial stability

Abstract:
Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2008), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.

liquidity risk, free-riding, narrow banking, lender of last resort

Abstract:
Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.

Liquidity Risk, Free-Riding, Narrow Banking, Lender of Last Resort