Bin Wei and Vivian Z. Yue

Working Paper 2015-13
December 2015

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Liquidity backstops have important implications for financial stability. In this paper, we provide a microfoundation for the important role of liquidity backstops in mitigating runs (or, conversely, the role of the lack of liquidity backstops in exacerbating runs) based on a dynamic model of debt runs. We focus on the municipal bond markets for variable rate demand obligations (VRDOs) and auction rate securities (ARS). The different experiences in these markets during the recent financial crisis of 2007–09 provide a natural experiment to identify the value of a liquidity backstop in mitigating runs. Through structural estimation of the model, we show that the value of a liquidity backstop is about 14.5 basis points per annum. The results in this paper shed light on one central difference between shadow banks and traditional banks in terms of their differential access to public liquidity backstops.

JEL classification: G10, G20, G21

Key words: liquidity backstop, debt run

For helpful comments and suggestions, the authors thank Linda Allen, Markus Brunnermeier, Jean-Edouard Colliard, Thierry Foucault, Song Han, Zhiguo He, Hyun Song Shin, Jeremy Stein, Gustavo Suarez, Paula Tkac, Wei Xiong, Larry Wall, and seminar participants at the Atlanta Fed, the Dallas Fed, Federal Reserve Board, the International Monetary Fund, the University of Texas at Dallas, Tsinghua University, Wuhan University, the 2014 American Finance Association meetings, the 2013 Society for Economic Dynamics meetings, the 2014 All-Georgia Finance conference, the 10th Central Bank Workshop, and the 2014 Computing in Economics and Finance conference. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Bin Wei, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8913,, or Vivian Z. Yue, Emory University, Federal Reserve Bank of Atlanta and NBER, Department of Economics, 602 Fishburne Drive, Atlanta, GA 30322, 404-727-0340,
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