Working Paper: CEPR ID: DP8953
Authors: Sylvester C.W. Eijffinger; Rob Nijskens
Abstract: Bailout expectations have led banks to behave imprudently, holding too little capital and relying too much on short term funding to finance long term investments. This paper presents a model to rationalize a constructive ambiguity approach to liquidity assistance as a solution to forbearance. Faced with a bank that chooses capital and liquidity, the institution providing liquidity assistance can commit to a mixed strategy: never bailing out is too costly and therefore not credible, while always bailing out causes moral hazard. In equilibrium, the bank chooses above minimum capital and liquidity, unless either capital costs or the opportunity cost of liquidity are too high. We also find that the probability of a bailout is higher for a regulator more concerned about bank failure, and when the bailout penalty for the bank is higher; this suggests that forbearance is not entirely eliminated by adopting ambiguity.
Keywords: banking; commitment; lender of last resort; liquidity; regulation
JEL Codes: E58; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulator's concern about bank failure (G28) | probability of bailout (H81) |
| bailout penalty (G28) | bank behavior (G21) |
| bailout expectations (G28) | bank behavior (G21) |
| bailout expectations (G28) | insufficient capital and excessive reliance on short-term funding (F65) |
| mixed strategy of ambiguity regarding bailouts (H81) | better capital and liquidity choices by banks (G21) |
| lump sum penalty for liquidity assistance (G33) | banks' incentives to maintain higher capital and reserve levels (G28) |
| regulatory concern (L51) | probability of bailout (H81) |