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Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis

  • Willem Spanjers

    ()

    (Institute for Research in Economic Evolution, University of Freiburg, Germany; School of Economics, Kingston University, United Kingdom; The Rimini Centre for Economic Analysis (RCEA), Italy)

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    For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector o ering deposit contracts. In a setting similar to Allen and Gale (1998) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns. In the context of the model, ambiguity | i.e. incalculable risk | leads to dynamically inconsistent investor behaviour. If the financial sector fails to recognize the presence of ambiguity, unanticipated fundamental crises may occur, which are incorrectly blamed on investors 'loosing their nerves' and 'panicing'. The basic mechanism of the current financial crisis resembles a banking panic in the presence of ambiguous asset returns. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model. A credible commitment to such 'bail-out policy' does not create a moral hazard problem. Rather, it implements the second best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability | as suggested by ordo-liberalism and the 'Freiburger Schule’ | enhances ex-ante welfare.

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    File URL: http://www.rcfea.org/RePEc/pdf/wp10_11.pdf
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    Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 10_11.

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    Date of creation: Jan 2011
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    Handle: RePEc:rim:rimwps:10_11
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