Sources of Liquidity and Liquidity Shortages

Abstract:     
This paper develops a model of liquidity provision in which a financial sector interacts with a liquidity-providing "household sector." Banks have varying need for liquid assets; they can use their own resources, borrow from other banks or households, or sell illiquid assets to fulfill these needs. Demand for liquidity imposes systemic externalities on other banks, but the nature of the externality depends on the degree of elasticity of the supply of liquidity from the household sector. If supply is liquid, then there is an unambiguous bias towards excessively illiquid holdings by banks. When the banking sector is large enough to affect the price of liquidity provided by households, then the direction of the inefficiency in bank liquidity holdings depends on the relative costs of raising external liquidity in anticipation of future shortages and after a liquidity shortage has already hit. We also use our model to analyze whether the banking sector produces an efficient degree of opacity, and if not, whether banks have incentives to invest in assets that are too opaque from a welfare perspective. We find that the answer again depends on the elasticity of liquidity supply from households and in addition on the source of asset opacity.

Number of Pages in PDF File: 35

Keywords: liquidity, banking crises, opacity

JEL Classification: G21, G28

working papers series