Discussion Paper Details

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Title: A dynamic analysis of bank bailouts and constructive ambiguity

Author(s): Sylvester C W Eijffinger and Rob Nijskens

Publication Date: April 2012

Keyword(s): banking, commitment, Lender of Last Resort, liquidity and regulation

Programme Area(s): International Macroeconomics

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.

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Bibliographic Reference

Eijffinger, S and Nijskens, R. 2012. 'A dynamic analysis of bank bailouts and constructive ambiguity'. London, Centre for Economic Policy Research.