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Liquidity, Contagion and Financial Crisis

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  • Guembel, Alexander
  • Sussman, Oren

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.

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Bibliographic Info

Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 664.

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Date of creation: 25 Jun 2010
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Handle: RePEc:ide:wpaper:24167

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Keywords: Debt deflation; Bailout; Liquidity Injection;

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  1. Gary Gorton & Lixin Huang, 2002. "Liquidity, Efficiency and Bank Bailouts," NBER Working Papers 9158, National Bureau of Economic Research, Inc.
  2. Oren Sussman & Javier Suarez, 2004. "Financial Distress, Bankruptcy Law and the Business Cycle," OFRC Working Papers Series 2004fe07, Oxford Financial Research Centre.
  3. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2011. "Crisis Resolution and Bank Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2166-2205.
  4. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank Liquidity, Interbank Markets and Monetary Policy," Working Papers 429, Barcelona Graduate School of Economics.
  5. Acharya, Viral V. & Shin, Hyun Song & Yorulmazer, Tanju, 2009. "A Theory of Slow-Moving Capital and Contagion," CEPR Discussion Papers 7147, C.E.P.R. Discussion Papers.
  6. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Banking Crises: An Equal Opportunity Menace," NBER Working Papers 14587, National Bureau of Economic Research, Inc.
  7. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
  8. Heider, Florian & Hoerova, Marie & Holthausen, Cornelia, 2010. "Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk," CEPR Discussion Papers 7762, C.E.P.R. Discussion Papers.
  9. Oren Sussman & Alexander Guembel, 2005. "Sovereign Debt Without Default Penalties," OFRC Working Papers Series 2005fe17, Oxford Financial Research Centre.
  10. Tobias Adrian & Hyun Song Shin, 2009. "Money, liquidity, and monetary policy," Staff Reports 360, Federal Reserve Bank of New York.
  11. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "The Aftermath of Financial Crises," American Economic Review, American Economic Association, vol. 99(2), pages 466-72, May.
  12. Ana Fostel & John Geanakoplos, 2008. "Collateral restrictions and liquidity under-supply: a simple model," Economic Theory, Springer, vol. 35(3), pages 441-467, June.
  13. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 97-116, November.
  14. Suarez, Javier & Sussman, Oren, 1997. "Endogenous Cycles in a Stiglitz-Weiss Economy," CEPR Discussion Papers 1604, C.E.P.R. Discussion Papers.
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