Interwoven Lending, Uncertainty, and Liquidity Hoarding

Abstract:     
This paper shows how uncertainties about funding in an interwoven system of intermediation can lead to excessive liquidity hoarding. In the model, funds are channeled through several financial intermediaries (banks) until they are finally invested in real assets. In case of a funding shock, banks that are uncertain about their own loans being rolled over, fear bankruptcy and cannot commit to rolling over loans they made to others either. This fear can lead local funding uncertainties to prompt banks to liquidate inefficiently large amounts of real assets without any defaults in equilibrium. The results hold even though the only source of risk aversion in the model is due to bankruptcy cost, banks are otherwise risk-neutral. The model suggests a novel explanation for the drop in lending during the Financial Crisis of 2007-2008.

Number of Pages in PDF File: 20

Keywords: financial network, interbank lending, TAF

JEL Classification: G20

working papers series