A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity

35 Pages Posted: 25 May 2012

See all articles by Sylvester C. W. Eijffinger

Sylvester C. W. Eijffinger

Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Rob Nijskens

De Nederlandsche Bank

Multiple version iconThere are 2 versions of this paper

Date Written: April 2012

Abstract

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.

Keywords: banking, commitment, Lender of Last Resort, liquidity, regulation

JEL Classification: E58, G21, G28

Suggested Citation

Eijffinger, Sylvester C. W. and Nijskens, Rob, A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity (April 2012). CEPR Discussion Paper No. DP8953, Available at SSRN: https://ssrn.com/abstract=2066326

Sylvester C. W. Eijffinger (Contact Author)

Tilburg University (CentER) - Department of Economics ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2411 (Phone)
+31 13 466 3042 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Rob Nijskens

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands
+31 20 524 3234 (Phone)

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