A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity
Sylvester C. W. Eijffinger
Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)
Tilburg University - Center for Economic Research (CentER); Tilburg University - European Banking Center; Tilburg University - Department of Economics
CEPR Discussion Paper No. DP8953
Bailout expectations have led banks to behave imprudently, holding too little capital and relying too much on short term funding to finance long term investments. This paper presents a model to rationalize a constructive ambiguity approach to liquidity assistance as a solution to forbearance. Faced with a bank that chooses capital and liquidity, the institution providing liquidity assistance can commit to a mixed strategy: never bailing out is too costly and therefore not credible, while always bailing out causes moral hazard. In equilibrium, the bank chooses above minimum capital and liquidity, unless either capital costs or the opportunity cost of liquidity are too high. We also find that the probability of a bailout is higher for a regulator more concerned about bank failure, and when the bailout penalty for the bank is higher; this suggests that forbearance is not entirely eliminated by adopting ambiguity.
Number of Pages in PDF File: 35
Keywords: banking, commitment, Lender of Last Resort, liquidity, regulation
JEL Classification: E58, G21, G28working papers series
Date posted: May 25, 2012
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