Liquidity backstops and dynamic debt runs

• Authors: Bin Wei, Emory University; Vivian Z. Yue, Emory University
• Journal Title: Journal of Economic Dynamics & Control
• Volume: Volume 116
• Publisher: Elsevier | 2020-07-31
• Type of Work: Article | Final Publisher PDF
• Publisher DOI: http://doi.org/10.1016/j.jedc.2020.103916
• Subjects: Economics, Finance; Business Administration, Banking; Economics, Theory
• Keywords: liquidity backstop; debt run; lender of last resort

Abstract

Liquidity backstops can mitigate runs. In this paper we develop a dynamic model of debt runs based on He and Xiong (2012) to identify, both conceptually and quantitatively, the value of a liquidity backstop for its run-mitigating role. For the purpose of identification, we focus on the municipal bond markets for variable rate demand obligations and auction rate securities. Based on the run episodes in these markets during the financial crisis of 2007-09 and the calibrated model, we find that the value of a liquidity backstop is about 14.5 basis points per annum. Our findings have important policy implications regarding the effectiveness of liquidity backstops in ameliorating problems of financial instability.