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Liquidity, Efficiency and Bank Bailouts

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Author Info
Gary Gorton
Lixin Huang

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Abstract

Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ( liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9158.

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Date of creation: Sep 2002
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Handle: RePEc:nbr:nberwo:9158

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Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Schanz, Jochen, 2009. "How do different models of foreign exchange settlement influence the risks and benefits of global liquidity management?," Bank of England working papers 374, Bank of England. [Downloadable!]
  2. Wagner, Wolf, 2006. "Diversification at financial institutions and systemic crises," Discussion Paper 71, Tilburg University, Center for Economic Research. [Downloadable!]
  3. Filippo Taddei, 2007. "Liquidity and the Allocation of Credit: Business Cycle, Government Debt and Financial Arrangements," Carlo Alberto Notebooks 65, Collegio Carlo Alberto. [Downloadable!]
  4. Brutti, Filippo, 2008. "Legal enforcement, public supply of liquidity and sovereign risk," MPRA Paper 13949, University Library of Munich, Germany. [Downloadable!]
  5. Kleopatra Nikolaou, 2009. "Liquidity (risk) concepts - definitions and interactions," Working Paper Series 1008, European Central Bank. [Downloadable!]
  6. Acharya, Viral V & Shin, Hyun Song & Yorulmazer, Tanju, 2007. "Fire Sales, Foreign Entry and Bank Liquidity," CEPR Discussion Papers 6309, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  7. Patrick Bolton & Tano Santos & Jose A. Scheinkman, 2009. "Outside and Inside Liquidity," NBER Working Papers 14867, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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