The Liquidity of Bank Assets and Banking Stability

Abstract

The emerging markets for credit derivatives have improved the liquidity of bank assets by providing banks with various new possibilities for selling and hedging their risks. This paper examines the consequences for banking stability. In a simple model where liquidation of bank assets is costly, we show that increased asset liquidity benefits stability by encouraging a representative bank to reduce the risks on its balance sheet. Stability is further enhanced because the bank can now liquidate assets in a crisis more easily. However, these effects are counteracted by increased risk-taking of the bank. We find that overall, stability actually falls. This is because the improved possibilities for liquidating assets in a crisis make a crisis less costly for the bank, which induces the bank to take on an amount of risk that more than offsets the initial positive impact on stability.

Keywords: Financial innovations, credit derivatives, risk taking, bank default, asset liquidity

JEL Classification: G21, G28