In Section 1.3, we showed that optimal liquidity management does not rely on inside liquidity, but rather on outside liquidity. Building on this, Section 1.4 revealed that the efficient allocation can be implemented by banks issuing private claims and relying on the rollover of debt. However, outside liquidity in exchange for privately produced assets is associated with a rollover risk. The anticipation of a rollover freeze can lead to inefficient investment choices ex- ante. We now analyze how this friction could be overcome. In particular, we ask whether the government can mitigate the problem by providing liquidity. In general, a government has the ability – unlike private agents – to commit future income via taxation or money creation. This makes claims against a public authority inherently safer than claims produced by the private sector. In the first part of this section, we therefore assume that the government never defaults. In this case, we show that the government can increase welfare by issuing a public claim that can be used by banks to manage liquidity. In the second part of this section, we relax the assumption that the government cannot default and show that the benefits from public provision of liquidity may vanish.
1.5.1 Liquidity Management and Government Bonds
Let us assume that the government never defaults. Consider the following mechanism in which the government provides liquidity by issuing a govern- ment bond (Figure 1.3): In t = 0, consumers deposit their endowment e0 at
a bank in exchange for a demand-deposit contract allowing the consumer to withdrawRe0 in either period. Banks receive government bonds that promise
a payment of b units by the government in t= 2. In exchange for the b gov- ernment bonds, banks write a debt contract with the government, promising to pay d units to the government in t = 2. Banks and government will lend and borrow such that d = b ≥ πRe0. Effectively, banks are expanding their
balance sheets by an amount of b.
Int = 1, banks sellπRe0 units of government bonds to the investors and use the resulting liquidity to serve withdrawing consumers. In t= 2, the govern- ment has due gross liabilities of b units, necessary to redeem the government bonds. An amount of πRe0 is paid to investors. The difference of b−πRe0
units is a gross liability towards banks, resulting from the government bonds they did not sell to investors in t = 1. However, the banks also owe d = b units to the government. Therefore, they have a net liability of πRe0 units
1.5 Public Outside Liquidity
long assets which is used to pay out (1−π)Re0 units to the patient consumers
and πRe0 to the government.
t= 0 t = 1 t= 2 Government Government Bank d b Bank Bank e0 πRe0 d Consumers e0 Consumers πRe0 Consumers (1–π)Re0 Investors πRe0 b Investors πRe0 b
Figure 1.3: Public Outside Liquidity. The graph illustrates investment and the flow of goods and claims. In this graph, we assume thatb=d=πe0R. The dotted arrow
denotes the investment in assets and thus the “transfer” of goods between periods. The solid arrows denote the flow of goods. The dashed arrows denote the flow of net claims. For simplicity, the claims of consumers towards banks (resulting from the demand-deposit contracts) are left out.
Proposition 1.5. If the government provides government bonds in t = 0, the banks are able to implement the first-best consumption allocation, given by c1(1) = c2(0) =Re0 and c1(0) = c2(1) = 0. Furthermore, the rollover risk
is eliminated and the economy has a unique equilibrium.
By expanding their balance sheet, the banks implement the first-best al- location while the rollover risk is completely eliminated. Even if all other investors refused to buy government bonds, this would not influence the in- centives of an individual investor. Public outside liquidity eliminates the coordination problem concerning the supply of liquidity by investors. Note though that public liquidity provision as described does not address the coor- dination problem between consumers concerning their withdrawal decisions. However, given that there is public outside liquidity, a bank run equilibrium can be eliminated by the standard measures, i.e., by introducing a deposit insurance or allowing banks to suspend convertibility. This is important as we saw in the previous section that these measures are ineffective as long as
the rollover problem is not addressed, but in this context they are effective at eliminating the coordination problem.
The central reason for the stability is that by assumption the government’s solvency, unlike that of a bank, does not depend on the behavior of investors. This eliminates any strategic considerations of investors when deciding to purchase government bonds in the interim period. Therefore, multiplicity of equilibria vanishes once government securities are used for liquidity manage- ment.20
Observe that there are alternative implementations of the first-best alloca- tion to the one shown in Figure 1.3. There are two obvious alternatives. First, the government could insure all current and future bank liabilities ex-ante. Second, the government could provide liquidity itself in the interim period. Both mechanisms are equivalent in terms of the results in our setup, as they also eliminate the fragility and thereby enhance efficiency. However, we ar- gue that both alternatives may not be equally desirable as they may be more problematic in a richer setup in which other issues such as agency problems may arise. Insuring bank liabilities may give rise to certain risks on behalf of the bank (e.g., risk-shifting) and creditors (e.g., weak disciplining effects). Moreover, if the government actively manages liquidity by lending directly to banks when they need funds, i.e., in a crisis, this may lead to excessive maturity mismatch as in, e.g., Farhi and Tirole (2012). We discuss these two issues in more depth in Section 6.
1.5.2 Government Solvency
So far, we have made the extreme assumption that the government is always able to repay its debt, irrespectively of what investors do and of whether there is a banking crisis. This assumption gives government bonds the important characteristic of being immune against rollover risk. We now relax this as- sumption in two different ways. First, we allow the government to default with some exogenous probability. We show that, in this case, public liquidity pro- vision may still be optimal. Second, we assume that the government’s ability to repay debt is endogenous and depends on the performance of the banking sector. In this case, the benefits from public liquidity provision vanish.
Assume first the government defaults with some positive probability which is given exogenously. This is not necessarily detrimental to efficiency and stability. Under the condition that investors are risk-neutral, and that the
20This is reminiscent of how multiplicity of equilibria is eliminated in the Kiyotaki and Moore (1997) model when government bonds are introduced (see p. 515 in Tirole, 2010).