Liquidity, Contagion and Financial Crisis

49 Pages Posted: 1 Jul 2010

See all articles by Alexander Guembel

Alexander Guembel

Toulouse School of Economics, University of Toulouse Capitole

Oren Sussman

University of Oxford - Said Business School; Ben-Gurion University of the Negev; University of London; University of Oxford - Said Business School

Date Written: June 25, 2010

Abstract

We develop a theoretical model where a redistribution of bank capital (e.g., due to reckless trading and/or faulty risk management) leads to a "freeze" of the interbank market. The fire-sale market plays a central role in spreading the crisis to the real economy. In crisis, credit rationing and liquidity hoarding appear simultaneously; endogenous levels of collateral (or margin requirements) are affected by both low fire-sale prices and high lending rates. Relative to previous analysis, this dual channel generates a stronger price and output effect. The main focus is on the policy analysis. We show that i) non-discriminating equity injections are more effective than liquidity injections, but in both the welfare effect is an order-of-magnitude lower than the price effect; ii) a discriminating policy that bails out only distressed banks is feasible but will be limited by incentive-compatibility constraints; iii) a restriction on international capital flows has an ambiguous effect on welfare.

Keywords: Debt deflation, bailout, liquidity injection

JEL Classification: G21, G28, G33

Suggested Citation

Guembel, Alexander and Sussman, Oren, Liquidity, Contagion and Financial Crisis (June 25, 2010). Available at SSRN: https://ssrn.com/abstract=1632825 or http://dx.doi.org/10.2139/ssrn.1632825

Alexander Guembel (Contact Author)

Toulouse School of Economics, University of Toulouse Capitole ( email )

Manufacture des Tabacs
21, allee de Brienne
Toulouse, 31000
France

Oren Sussman

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 926 (Phone)
+44 1865 288 805 (Fax)

Ben-Gurion University of the Negev

1 Ben-Gurion Blvd
Beer-Sheva 84105, 84105
ISRAEL

University of London ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 926 (Phone)
+44 1865 288 805 (Fax)

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