No abstract

No abstract

No abstract

As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in "cash-in-the-market" pricing for liquidation of banking assets. At a su¢ ciently large number of bank failures, and in turn, at a su¢ ciently low level of asset prices, there are too many banks to liquidate and ine¢ cient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation ine¢ ciency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a liquidity provision policy involving regulatory assistance to surviving banks in the purchase of failed banks that is ex-post equivalent to the bailout policy from a social welfare standpoint. Crucially, the liquidity provision policy gives banks incentives to di¤erentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.J.E.L. Classi…cation: G21, G28, G38, E58, D62.

The sub-prime crisis of 2007 and 2008 has been characterized by a sudden freeze in the market for short-term, secured borrowing. We present a model that can explain a sudden collapse in the amount that can be borrowed against assets with little credit risk. The borrowing in this model takes the form of asset-backed commercial paper that has to be rolled over several times before the underlying assets mature and their true value is revealed. In the event of default, the creditors (holders of commercial paper) can seize the collateral. We assume that there is a small cost of liquidating the assets. The debt capacity of the assets (the maximum amount that can be borrowed using the assets as collateral) depends on how information about the quality of the asset is revealed. In one scenario, there is a constant probability that "bad news" is revealed each period and, in the absence of bad news, the value of the assets is high. We call this the "optimistic" scenario because, in the absence of bad news, the expected value of the assets is increasing over time. By contrast, in another scenario, there is a constant probability that "good news" is revealed each period and, in the absence of good news, the value of the assets is low. We call this the "pessimistic" scenario because, in the absence of good news, the expected value of the assets is decreasing over time. In the optimistic scenario, the debt capacity of the assets is equal to the fundamental value (the expected NPV), whereas in the pessimistic scenario, the debt capacity is below the fundamental value and is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.J.E.L. Classification: G12, G21, G24, G32, G33, D8.