A dynamic analysis of bank bailouts and constructive ambiguity

Sylvester Eijffinger and Rob Nijskens

No 8953, CEPR Discussion Papers from Centre for Economic Policy Research

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 (search for similar items in EconPapers)
JEL-codes: E58 G21 G28 (search for similar items in EconPapers)
Date: 2012-04
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cta and nep-mac
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