A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity
35 Pages Posted: 25 May 2012
There are 2 versions of this paper
A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity
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: Suggested Citation
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A Dynamic Analysis of Bank Bailouts and Constructive Ambiguity