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A Global Game Analysis of Emergent Liquidity Provision and the Role of Creditors' Aggregate Behavior as Signaling

August 2011
Junnosuke Shino*1

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Recent funding problems experienced by European sovereigns and the subsequent policy actions have renewed interest in emergent liquidity provision or the international Lender of Last Resort. This paper constructs an abstract model about emergent liquidity lending by using global game techniques. Compared with the existing models, our model can be characterized by the followings: (1) the authority to provide liquidity (policy maker) is an explicit player in the game rather than an implicit unity appeared in comparative statics, (2) the policy maker cannot distinguish between solvency and insolvency of the liquidity borrower ex ante, (3) liquidity lending rates are endogenously determined, and (4) the policy maker's decision making is set after observing creditors' aggregate behaviors of withdrawing their loans to the borrower. With this setup, it is shown that: (1) creditors' aggregate behavior operates as a signal to the policy maker about borrower's solvency, (2) the policy maker's optimal strategy is to help only illiquid but solvent borrowers, (3) whenever the liquidity lending facility is utilized, optimal lending rates are strictly positive, and (4) the optimal lending rates are "conditionally punitive" in the sense that they take the highest level possible under the restriction that the rates enable solvent but illiquid borrowers to survive.

The author is grateful for valuable comments from Michael Bordo, Colin Campbell, Ippei Fujiwara, Masazumi Hattori, Yuichiro Kamada, Yukisato Ohta, Daijiro Okada, Jean-Charles Rochet, Tomas Sjöström, and seminar participants at 6th Pan Pacific Conference on Game Theory, Tokyo Institute of Technology, February 28, 2011 and Game Theory Workshop, Nagoya University, March 6, 2011.

  •   *1 Financial Markets Department (currently Research and Statistics Department), Bank of Japan.
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