Liquidity, Efficiency and Bank Bailouts

45 Pages Posted: 15 Sep 2002 Last revised: 28 Oct 2010

See all articles by Gary B. Gorton

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER); Yale University - Yale Program on Financial Stability

Lixin Huang

Georgia State University

Date Written: September 2002

Abstract

Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ( liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

Suggested Citation

Gorton, Gary B. and Huang, Lixin, Liquidity, Efficiency and Bank Bailouts (September 2002). NBER Working Paper No. w9158. Available at SSRN: https://ssrn.com/abstract=330992

Gary B. Gorton (Contact Author)

Yale School of Management ( email )

165 Whitney Ave
P.O. Box 208200
New haven, CT 06511
United States

HOME PAGE: http://mba.yale.edu/faculty/profiles/gorton.shtml

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yale University - Yale Program on Financial Stability

165 Whitney Avenue
P.O. Box 208200
New Haven, CT 06520-8200
United States

Lixin Huang

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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