A Global Game Analysis of Emergent Liquidity Provision and the Role of Creditors' Aggregate Behavior as Signaling

Junnosuke Shino

No 11-E-7, Bank of Japan Working Paper Series from Bank of Japan

Abstract: Recent funding problems experienced by European sovereigns and the subsequent policy actions have renewed interest in emergent liquidity provision or the international Lender of Last Resort. This paper constructs an abstract model about emergent liquidity lending by using global game techniques. Compared with the existing models, our model can be characterized by the followings: (1) the authority to provide liquidity (policy maker) is an explicit player in the game rather than an implicit unity appeared in comparative statics, (2) the policy maker cannot distinguish between solvency and insolvency of the liquidity borrower ex ante, (3) liquidity lending rates are endogenously determined, and (4) the policy maker's decision making is set after observing creditors' aggregate behaviors of withdrawing their loans to the borrower. With this setup, it is shown that: (1) creditors' aggregate behavior operates as a signal to the policy maker about borrower's solvency, (2) the policy maker's optimal strategy is to help only illiquid but solvent borrowers, (3) whenever the liquidity lending facility is utilized, optimal lending rates are strictly positive, and (4) the optimal lending rates are "conditionally punitive" in the sense that they take the highest level possible under the restriction that the rates enable solvent but illiquid borrowers to survive.

Date: 2011-08
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