Credit Market Competition and Liquidity Crises

47 Pages Posted: 13 Mar 2014

See all articles by Elena Carletti

Elena Carletti

Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Agnese Leonello

European Central Bank, Financial Research Division

Multiple version iconThere are 2 versions of this paper

Date Written: February 21, 2014

Abstract

We develop a model where banks invest in reserves and loans, and face aggregate liquidity shocks. Banks with liquidity shortage sell loans on the interbank market. Two equilibria emerge. In the no default equilibrium, all banks hold enough reserves and remain solvent. In the mixed equilibrium, some banks default with positive probability. The former exists when credit market competition is intense. The latter emerges when banks exercise market power. Thus, competition is beneficial to financial stability. The structure of liquidity shocks affects the severity and the occurrence of crises, as well as the amount of credit available in the economy.

Keywords: interbank market, default, price volatility

JEL Classification: G010, G210

Suggested Citation

Carletti, Elena and Leonello, Agnese, Credit Market Competition and Liquidity Crises (February 21, 2014). CESifo Working Paper Series No. 4647. Available at SSRN: https://ssrn.com/abstract=2407884

Elena Carletti (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

Agnese Leonello

European Central Bank, Financial Research Division ( email )

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