Inside Liquidity in Competitive Markets

Abstract

We study incentives of financial intermediaries to reserve liquidity given that they can rely on the interbank market for their liquidity needs. On date one all intermediaries are homogeneous and they choose how much funds to invest in long-term projects and how much to reserve in the form of liquid assets. On date two a crisis might hit, in which case the intermediaries experience idiosyncratic liquidity shocks. Intermediaries with liquidity needs can borrow liquidity against their pledgeable investments from the intermediaries with liquidity surpluses. These investments are partially pledgeable to other intermediaries, but not to the rest of the economy, therefore liquidity provision is endogenous. On date three the investments yield returns and the debt contracts are settled. We show that if the probability of a crisis is large or if investments are slightly pledgeable, then all intermediaries reserve some liquidity, though there is an overall underprovision of liquidity. However, if the probability of a crisis is small or if investments are highly pledgeable, then intermediaries segregate: some reserve no liquidity, others reserve to the maximum and become liquidity providers. We further study the impacts of introducing minimum liquidity requirements and of announcing a favourable interest rate policy in case of a crisis. Minimum liquidity requirement improve welfare only in the symmetric equilibrium. Marginally lowering the interest rate causes a marginal crowding-out of private liquidity with public liquidity in the symmetric equilibrium, but a full crowding-out in the asymmetric equilibrium.

Keywords: inside liquidity, partial pledgeability, interbank markets, minimum liquidity requirements, central bank

JEL Classification: E43, G20, G33