Liquidity Risk, Credit Risk, and Interbank Competition

49 Pages Posted: 11 Mar 2008 Last revised: 4 Dec 2008

See all articles by Jian Cai

Jian Cai

Washington University in St. Louis

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Date Written: November 19, 2008

Abstract

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

Cai, Jian and Thakor, Anjan V., Liquidity Risk, Credit Risk, and Interbank Competition (November 19, 2008). AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1103548 or http://dx.doi.org/10.2139/ssrn.1103548

Jian Cai

Washington University in St. Louis ( email )

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
74
Abstract Views
330
PlumX Metrics