Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis

For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector oering 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 are 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. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model. A credible commitment to such 'bail-out policy' does not create a moral hazard problem. Rather, it implements the second best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability | as suggested by ordo-liberalism and the 'Freiburger Schule’ | enhances ex-ante welfare.