DP8453 | Bailout Uncertainty in a Microfounded General Equilibrium Model of the Financial System

Publication Date

01/06/2011

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

This paper develops a micro-founded general equilibrium model of the financial system composed of ultimate borrowers, ultimate lenders and financial intermediaries. The model is used to investigate the impact of uncertainty about the likelihood of governmental bailouts on leverage, interest rates, the volume of defaults and the real economy. The distinction between risk and uncertainty is implemented by applying the Gilboa-Schmeidler maxmin with multiple priors framework to lenders' beliefs about the probability of bailout. Events like Lehman's collapse are conceived of as 'black swan' events that led lenders to put a positive mass on bailout probabilities that were previously assigned zero mass. Results of the analysis include: (i) An unanticipated increase in bailout uncertainty raises interest rates, the volume of defaults in both the real and financial sectors and may lead to a total drying up of credit markets. (ii) Lower exante bailout uncertainty is conducive to higher leverage - which raises moral hazard and makes the economy more vulnerable to expost increases in bailout uncertainty. (iii) Bailout uncertainty raises the likelihood of bubbles, the amplitude of booms and busts as well as the banking and the credit spreads. (iv) Bailout uncertainty is associated with higher returns? variability in diversified portfolios and systemic risks, (v) Expansionary monetary policy reinforces those effects by inducing higher aggregate leverage levels.