Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis
Review of Economic Analysis 10 (2018), 371-407
37 Pages Posted: 6 Jun 2019
Date Written: December 1, 2018
For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector offering deposit contracts. In a setting related to Allen and Gale (1998) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns. In the context of our model, ambiguity – i.e. incalculable risk – leads to dynamically inconsistent investor behavior. If the financial sector fails to recognize the presence of ambiguity, unanticipated fundamental crises may occur, which are incorrectly blamed on investors ‘losing their nerves’ and ‘panicking’. The basic mechanism of the Financial Crisis resembles the liquidation of illiquid assets during a banking panic. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model. A credible commitment to such ‘bail-out policy’ does not create a moral hazard problem. Rather, it implements the second-best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability – as suggested by ordo-liberalism and the ‘Freiburger Schule’ – enhances ex-ante welfare.
Keywords: Financial Intermediation, Liquidity, Ambiguity, Choquet Expected Utility, Financial Crisis
JEL Classification: D8, G1, G2
Suggested Citation: Suggested Citation