CXO

Liquidity Provision, Ambiguous Asset Returns And The Financial Crisis

Date Added: Jan 2011
Format: PDF

For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitve banking sector offering deposit contracts. In a setting similar to Allen and Gale (1998,) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns. In the context of the model, ambiguity - i.e. incalculable risk - leads to dynamically inconsistent investor behaviour. If the financial sector fails to recognize the presence of ambiguity, unanticipated fundamental crises may occur, which is incorrectly blamed on investors 'Loosing their nerves' and 'Panicing'. The basic mechanism of the current financial crisis resembles a banking panic in the presence of ambiguous asset returns.