Liquidity Crisis - Role For Policy

Role For Policy

There exists scope for government policy to alleviate a liquidity crunch, by absorbing less liquid assets and in turn providing the private sector with more liquid government – backed assets, through the following channels :

Pre-Emptive or Ex-Ante Policy Imposition of minimum equity:capital requirements or ceilings on debt-to-equity ratio on financial institutions other than commercial banks would lead to more resilient balance sheets. In the context of the Diamond–Dybvig model, an example of a demand deposit contract that mitigates banks’ vulnerability to bank runs, while allowing them to be providers of liquidity and optimal risk sharing, is one that entails suspension of convertibility when there are too many withdrawals. For instance, consider a contract which is identical to the pure demand deposit contract, except that it states that a depositor will not receive anything on a given date if he attempts to prematurely withdraw, after a certain fraction of the bank’s total deposits have been withdrawn. Such a contract has a unique Nash Equilibrium which is stable and achieves optimal risk sharing.

Expost Policy Intervention Some experts suggest that the Central Bank should provide downside insurance in the event of a liquidity crisis. This could take the form of direct provision of insurance to asset-holders against losses or a commitment to purchasing assets in the event that the asset price falls below a threshold. Such ‘Asset Purchases’ will help drive up the demand and consequently the price of the asset in question, thereby easing the liquidity shortage faced by borrowers. Alternatively, the Government could provide ‘deposit insurance’, where it guarantees that a promised return will be paid to all those who withdraw. In the framework of the Diamond Dybvig model, demand deposit contracts with government deposit insurance help achieve the optimal equilibrium if the Government imposes an optimal tax to finance the deposit insurance. Alternative mechanisms through which the Central Bank could intervene are direct injection of equity into the system in the event of a liquidity crunch or engaging in a debt for equity swap. It could also lend through the discount window, providing credit to distressed financial institutions on easier terms. However, it is argued by many economists that if the Central Bank declares itself as a ‘Lender of Last Resort’ (LLR), this might result in a moral hazard problem, with the private sector becoming lapse and this may even exacerbate the problem. Many economists therefore assert that the LLR must only be employed in extreme cases and must be a discretion of the Government rather than a rule.