Liquidity Shortages and Monetary Policy

The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection could make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. JEL classification: E5, G21, G28 We would like to thank Charles Goodhart and Stephan Sauer for useful comments Department of Economics University of Munich D-80539 Munich /Germany * Munich Graduate School of Economics (MGSE); Email: [email protected] ** University of Munich and CESifo; Email: [email protected] “Moral hazard fundamentalists misunderstand the insurance analogy” Lawrence Summers, Financial Times, Sept. 24 2007 “Just as imprudent banks have been saved from their mistakes by indulgent central bankers, so CDO-makers could be rewarded for the mess that they helped to create. ... The creators of CDOs and conduits may end the year with new Porsches. Vroom-vroom.” Croesus's cousins, Economist, Sept. 22 2007