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Liquidity, Contagion and Financial Crisis

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  • Economics


guembel sussman - liquidity contagion crisis - submission- june - 2010.dvi Liquidity, Contagion and Financial Crisis∗ Alexander Guembel Toulouse School of Economics (IAE, IDEI) Oren Sussman Saïd Business School, University of Oxford 25 June, 2010 ∗We would like to thank Benno Buehler, Ethan Cohen-Cole, Jean-Charles Rochet, Jean Tirole, audiences at the SAET 2009 meetings, the ECB-CFS research network conference 2009, and seminar participants at Heriot Watt, Imperial College and Vienna University for helpful comments. This research benefited from the support of the research grant "Financial Markets and Investment Banking Value Chain" sponsored by the Fédération Bancaire Française. All remaining errors are ours. Correspondence address: Oren Sussman, Saïd Business School, Oxford, OX1 1HP, UK, Tel.: +44 1865 288 926, e-mail: [email protected] Liquidity, Contagion and Financial Crisis ABSTRACT We develop a theoretical model where a redistribution of bank capital (e.g., due to reckless trading and/or faulty risk management) leads to a “freeze” of the interbank market. The fire-sale market plays a central role in spreading the crisis to the real economy. In crisis, credit rationing and liquidity hoarding appear simultaneously; endogenous levels of col- lateral (or margin requirements) are affected by both low fire-sale prices and high lending rates. Relative to previous analysis, this dual channel generates a stronger price and output effect. The main focus is on the policy analysis. We show that i) non-discriminating equity injections are more effective than liquidity injections, but in both the welfare effect is an order-of-magnitude lower than the price effect; ii) a discriminating policy that bails out only distressed banks is feasible but will be limited by incentive-compatibility constraints; iii) a restriction on international capital flows has an ambiguous effect on welfare. Keywords: Debt deflation, bailout, liquidity injection JEL Class

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