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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 Toulouse School of Economics (TSE) in its series TSE Working Papers with number 10-240.

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Date of creation: 25 Jun 2010
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Handle: RePEc:tse:wpaper:24590

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Keywords: Debt deflation; Bailout; Liquidity Injection;

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References

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  1. 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.
  2. Gary Gorton & Lixin Huang, 2002. "Liquidity, Efficiency and Bank Bailouts," Center for Financial Institutions Working Papers 02-33, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Ana Fostel & John Geanakoplos, 2004. "Collateral Restrictions and Liquidity Under-Supply: A Simple Model," Cowles Foundation Discussion Papers 1468R, Cowles Foundation for Research in Economics, Yale University, revised Aug 2006.
  4. Suarez,J. & Sussman,O., 1995. "Endogenous Cycles in a Stiglitz-Weiss Economy," Papers 9518, Centro de Estudios Monetarios Y Financieros-.
  5. 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.
  6. Tobias Adrian & Hyun Song Shin, 2009. "Money, Liquidity, and Monetary Policy," American Economic Review, American Economic Association, vol. 99(2), pages 600-605, May.
  7. Javier Suarez & Oren Sussman, 2007. "Financial distress, bankruptcy law and the business cycle," Annals of Finance, Springer, vol. 3(1), pages 5-35, January.
  8. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank liquidity, interbank markets and monetary policy," Economics Working Papers 1202, Department of Economics and Business, Universitat Pompeu Fabra.
  9. Oren Sussman & Alexander Guembel, 2005. "Sovereign Debt Without Default Penalties," OFRC Working Papers Series 2005fe17, Oxford Financial Research Centre.
  10. Reinhart, Carmen & Rogoff, Kenneth, 2009. "Banking Crises: An Equal Opportunity Menace," CEPR Discussion Papers 7131, C.E.P.R. Discussion Papers.
  11. Heider, Florian & Hoerova, Marie & Holthausen, Cornelia, 2009. "Liquidity hoarding and interbank market spreads: the role of counterparty risk," Working Paper Series 1126, European Central Bank.
  12. 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.
  13. 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.
  14. Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
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