Uncertainty, Liquidity, and Financial Crisis
RILE Working Paper No. 2011/8
56 Pages Posted: 1 Dec 2011 Last revised: 24 Jun 2013
Date Written: May 8, 2012
This paper investigates the determinants of liquidity crises based on the dynamics of banking and finance under uncertainty. The explanatory power of this framework is tested against the events of the global financial crisis. Despite limited availability of data that can proxy for uncertainty, this approach seems to explain better than others how a relatively small shock, such as the default of subprime mortgages, could trigger a systemic crisis.
The analysis confirms Minsky’s hypothesis of endogenous financial instability derived from Keynes’s theory of liquidity and expectations. Conventional expectations allow overcoming uncertainty via the liquidity of secondary markets and, in turn, of banks’ liabilities that are accepted as money. However, the failure of existing conventions precipitates the system into uncertainty-driven liquidity spirals, which are the more dangerous the more private money financial intermediaries have managed to create in the first place.
This approach has a number of policy implications, two of which are discussed in this paper.
First, financial crises should be policed by tailoring the lender of last resort function of central banks to the creation of private money. By the same token, banking should be defined and regulated according to this monetary function performed by financial intermediaries, whether banks or non-banks. These institutions should face payout restrictions while being prevented from using retained earnings to increase the quantity of private money they can create through their balance sheet.
Second, corporate governance of banks should insulate managers and controlling shareholders from the short-termism of stock markets. Inasmuch as myopic stock markets drive balance sheet choices of banks, investor-friendly corporate governance is a major amplifier of liquidity crises. This paper thus suggests combining long-term remuneration with the possibility for bank managers to claim a compensation for parting with control. Similar implications are derived for controlling shareholders.
Keywords: uncertainty, financial crisis, expectations, securitization, haircuts, liquidity, lender of last resort, corporate governance, private benefits of control
JEL Classification: D80, G01, G28, G38, K22
Suggested Citation: Suggested Citation