Bailout Uncertainty in a Microfounded General Equilibrium Model of the Financial System
AbstractThis paper develops a micro-founded general equilibrium model of the financial system composed of ultimate borrowers, ultimate lenders and financial intermediaries. The model is used to investigate the impact of uncertainty about the likelihood of governmental bailouts on leverage, interest rates, the volume of defaults and the real economy. The distinction between risk and uncertainty is implemented by applying the Gilboa-Schmeidler maxmin with multiple priors framework to lenders' beliefs about the probability of bailout. Events like Lehman's collapse are conceived of as 'black swan' events that led lenders to put a positive mass on bailout probabilities that were previously assigned zero mass. Results of the analysis include: (i) An unanticipated increase in bailout uncertainty raises interest rates, the volume of defaults in both the real and financial sectors and may lead to a total drying up of credit markets. (ii) Lower exante bailout uncertainty is conducive to higher leverage - which raises moral hazard and makes the economy more vulnerable to expost increases in bailout uncertainty. (iii) Bailout uncertainty raises the likelihood of bubbles, the amplitude of booms and busts as well as the banking and the credit spreads. (iv) Bailout uncertainty is associated with higher returns’ variability in diversified portfolios and systemic risks, (v) Expansionary monetary policy reinforces those effects by inducing higher aggregate leverage levels.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8453.
Date of creation: Jun 2011
Date of revision:
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Find related papers by JEL classification:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
- E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
- E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
- G01 - Financial Economics - - General - - - Financial Crises
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- G2 - Financial Economics - - Financial Institutions and Services
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-07-13 (All new papers)
- NEP-BAN-2011-07-13 (Banking)
- NEP-CBA-2011-07-13 (Central Banking)
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