Abstract

http://ssrn.com/abstract=1888967
 
 

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Bailout Uncertainty in a Microfounded General Equilibrium Model of the Financial System


Alex Cukierman


Tel Aviv University - Eitan Berglas School of Economics; Interdisciplinary Center (IDC) Herzliyah; Centre for Economic Policy Research (CEPR)

Yehuda (Yud) Izhakian


New York University (NYU) - Leonard N. Stern School of Business

June 1, 2011

Paolo Baffi Centre Research Paper No. 2011-104

Abstract:     
This paper develops a micro-founded general equilibrium model of the financial system composed of ultimate borrowers, ultimate lenders and financial intermediaries. The model is used to investigate the impact of uncertainty about the likelihood of governmental bailouts on leverage, interest rates, the volume of defaults and the real economy. The distinction between risk and uncertainty is implemented by applying the Gilboa-Schmeidler (1989) maxmin with multiple priors framework to lenders’ beliefs about the probability of bailout. Events like Lehman’s collapse are conceived of as ”black swan” events that led lenders to put a positive mass on bailout probabilities that were previously assigned zero mass.

Results of the analysis include: (i) An unanticipated increase in bailout uncertainty raises interest rates, the volume of defaults in both the real and financial sectors and may lead to a total drying up of credit markets. (ii) Lower exante bailout uncertainty is conducive to higher leverage - which raises moral hazard and makes the economy more vulnerable to expost increases in bailout uncertainty. (iii) Bailout uncertainty raises the likelihood of bubbles, the amplitude of booms and busts as well as the banking and the credit spreads. (iv) Bailout uncertainty is associated with higher returns’ variability in diversified portfolios and systemic risks, (v) Expansionary monetary policy reinforces those effects by inducing higher aggregate leverage levels.

Number of Pages in PDF File: 52

Keywords: Risk, Uncertainty, Lehman’s default, Leverage, Financial intermediaries, Bailouts, Duration mismatches

JEL Classification: G01, G11, G2, G18, E3, E4, E5, E6, D81, D83

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Date posted: July 20, 2011  

Suggested Citation

Cukierman, Alex and Izhakian, Yehuda (Yud), Bailout Uncertainty in a Microfounded General Equilibrium Model of the Financial System (June 1, 2011). Paolo Baffi Centre Research Paper No. 2011-104. Available at SSRN: http://ssrn.com/abstract=1888967 or http://dx.doi.org/10.2139/ssrn.1888967

Contact Information

Alex Cukierman
Tel Aviv University - Eitan Berglas School of Economics ( email )
P.O. Box 39040
Ramat Aviv, Tel Aviv, 69978
Israel
+972 3 540 5360 (Phone)
+972 3 640 9908 (Fax)
Interdisciplinary Center (IDC) Herzliyah ( email )
P.O. Box 167
Herzliya, 46150
Israel
HOME PAGE: http://www.tau.ac.il/~alexcuk/
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Yehuda (Yud) Izhakian (Contact Author)
New York University (NYU) - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://people.stern.nyu.edu/yizhakia/
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