Liquidity, Payment and Endogenous Financial Fragility

Abstract:     
We study the fragility of the banking system in relation to its role in liquidity creation. In our framework, fragility stems from the interconnections banks establish to protect themselves from liquidity shocks. In the absence of contractual constraints, banks choose the optimal degree of mutual insurance, because market participants correctly take into account the economic effects of their own interdependence. When banks are in the business of providing liquidity, some contractual flexibility is missing. In this case, we show that banks have an incentive to become too risky in aggregate, since some of the beneficiaries of the liquidity provision are unable to compensate the banks for remaining solvent. We examine possible regulatory remedies for this problem.

Number of Pages in PDF File: 36

Keywords: Systemic risk, liquidity, payment services, bank regulation

JEL Classification: G21, G28

working papers series