Where Should Liquidity be Injected During a Financial Crisis?

Abstract

Over the past two years, the Federal Reserve has extended credit to several institutions, intervening in several financial markets. This paper provides a model to analyze the relative effectiveness of the different policies of injecting liquidity in different markets. The three key ingredients of the model are: (i) a financial market with many different agents, (ii) securitization and asset-backed securities playing a key role in funding, (iii) leveraged positions by investors with their equity being marked to market. The model suggests that the most effective way to inject liquidity is through equity injections to the investors in securities markets. In particular, it is more effective than to extend credit to the originators of loans.