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

52 Pages Posted: 20 Jul 2011  

Alex Cukierman

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

Yehuda (Yud) Izhakian

City University of New York, CUNY Baruch College - Zicklin School of Business - Department of Economics and Finance

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Date Written: June 1, 2011

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.

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

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

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: https://ssrn.com/abstract=1888967 or http://dx.doi.org/10.2139/ssrn.1888967

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)

City University of New York, CUNY Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

17 Lexington Avenue
New York, NY 10010
United States

HOME PAGE: http://people.stern.nyu.edu/yizhakia/

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