FINANCIAL MARKETS, INSTITUTIONS AND INSTRUMENTS

Financial Markets, Institutions and Instruments

Financial Markets, Institutions and Instruments

Introduction

This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating (nonfinancial) firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, we show, inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because (and only because) of their (self-fulfilling) expectations that other banks will not be lending. We show how inefficient credit freeze equilibria may result from the arrival of information about fundamentals or a negative shock to the banking system's capitalization. While such equilibria result from the arrival of information about fundamentals, they do represent a “coordination failure:” banks' separate and fully rational decisions produce an outcome that would have been avoided had they been able to choose a coordinated action. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of (1) interest rate cuts, (2) infusion of capital into financial firms, (3) direct lending to operating firms by the government, (4) lending to operating firms by funds owned by the government and managed by private agents compensated with a share of the profits generated by the fund, and (5) provision of guarantees by the government against losses incurred by banks on loans to operating firms. Throughout, we discuss the implications of our analysis for understanding and responding to the credit crisis of 2008 (Bebchuk, 2008a, 65).

Discussion

An important aspect of the economic crisis of 2008-2009 has been the “freezing” of credit to nonfinancial firms.1 During the fall of 2008, despite government efforts to provide substantial liquidity and additional capital to the financial sector, financial firms have displayed considerable reluctance to extend loans to nonfinancial firms (as well as households). Because governments have traditionally left to the financial sector the role of lending to nonfinancial firms, financial firms' reluctance to lend to nonfinancial firms, and their election to hoard their capital for the time being, can have severe consequences for the economy. Some observers have attributed the reluctance of financial firms to lend to irrational fear, while others have attributed it to a rational assessment of the fundamentals of the economy which can be expected to make it difficult for operating firms to repay extended loans. This paper develops a model of how coordination failure among financial institutions, and self-fulfilling rational expectations, can lead to inefficient “credit markets freeze” equilibria. In such equilibria, financial institutions rationally avoid lending to nonfinancial firms (operating firms) that have projects that would be worthy if banks did not withdraw from the lending market en masse, doing so out of self-fulfilling fear, validated in equilibrium, that other financial institutions would withhold loans and that operating companies would not be able to succeed in an ...