Working paper
Liquidity, Contagion and Financial Crisis
Alexander Guembel, and Oren Sussman
IDEI Working Paper
n. 664, June 25, 2010
Reference
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;
JEL codes
- G21: Banks • Depository Institutions • Micro Finance Institutions • Mortgages
- G28: Government Policy and Regulation
- G33: Bankruptcy • Liquidation