Article in a working paper series:

Alexander Guembel and Oren Sussman, "Liquidity, Contagion and Financial Crisis", IDEI Working Paper, n. 664, June 25, 2010.

Abstract

We develop a theoretical model where a redistribution of bank capital (e.g., due to reckless trading and/or faulty risk management) leads to a “freeze” of the interbank market. The fire-sale market plays a central role in spreading the crisis to the real economy. In crisis, credit rationing and liquidity hoarding appear simultaneously; endogenous levels of collateral (or margin requirements) are affected by both low fire-sale prices and high lending rates. Relative to previous analysis, this dual channel generates a stronger price and output effect. The main focus is on the policy analysis. We show that i) non-discriminating equity injections are more effective than liquidity injections, but in both the welfare effect is an order-of-magnitude lower than the price effect; ii) a discriminating policy that bails out only distressed banks is feasible but will be limited by incentive-compatibility constraints; iii) a restriction on international capital flows has an ambiguous effect on welfare.

Keywords

Debt deflation, Bailout, Liquidity Injection

IDEI's theme of research

Insurance, Banking and Finance

JEL codes

G21: Banks; Other Depository Institutions; Mortgages
G28: Government Policy and Regulation
G33: Bankruptcy; Liquidation

Research programs

Fédération des Banques Françaises Research Initiative on Investment banking and financial markets

FBF research theme

Systemic risk, bank regulation and public policy