Liquidity Risk, Credit Risk, and Interbank Competition
49 Pages Posted: 11 Mar 2008 Last revised: 4 Dec 2008
Date Written: November 19, 2008
This paper examines the impact of interbank competition on liquidity risk and on the interaction between liquidity and credit risks. We first show that financial intermediation with deposit insurance may increase the impact of liquidity risk, so that intermediated loans may carry higher liquidity premia for borrowers than market-financed loans. Second, with negligible interbank competition, higher credit risk may reduce liquidity risk, so a bank's need for liquidity may also induce it to take on additional credit risk. Third, we show that Bertrand competition among banks in the loan market, introduced by outside lenders purchasing the relationship-specific liquidation skill of the incumbent lender, has two potential effects: (i) it can improve loan liquidity, and (ii) it can make credit and liquidity risks comonotonic, thereby reducing the inclination of banks to take on excessive credit risk to cope with their liquidity needs. However, interbank competition improves loan liquidity only under some conditions. We identify conditions under which greater interbank competition increases loan liquidity and reduces each bank's overall risk, which includes credit and liquidity risks.
Keywords: Liquidity risk, Credit risk, Interbank competition, Financial intermediation, Relationship lending
JEL Classification: G21
Suggested Citation: Suggested Citation