Banks’ Liquidity Management and Systemic Risk

TitleBanks’ Liquidity Management and Systemic Risk
Publication TypeWorking Paper
Year of Publication2017
AuthorsLG. Deidda, E. Panetti
Number2017_05
ISBN Number978 88 9386 035 2
Keywordsbank runs, excess liquidity, global games, systemic risk
Abstract

We study a novel mechanism to explain the interaction between banks’ liquidity management and the emergence of systemic financial crises, in the form of self-fulfilling runs. To this end, we develop an environment where banks offer insurance to their depositors against both idiosyncratic and aggregate real shocks, by holding a portfolio of liquidity and illiquid productive assets. Moreover, banks’ asset portfolios and the probability of a depositors’ self-fulfilling run are jointly determined via a “global game”. We characterize the sufficient conditions under which there exists a unique threshold recovery rate, associated with the early liquidation of the productive assets, below which the banks first employ liquidity and then liquidate, in order to finance depositors’ early withdrawals. Ex ante, the banks hold more liquidity than in a full-information economy, where there are no self-fulfilling runs and risk is only due to idiosyncratic and aggregate real shocks.

Citation Key7054
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