Liquidity Management, Fire Sales and Liquidity Crises in Banking: The Role of Leverage

41 Pages Posted: 28 Nov 2015 Last revised: 31 Mar 2019

Date Written: March 29, 2019

Abstract

This paper proposes a positive theory of the links between banks' capitalisation and their liquidity risk taking, the extent of fire-sale problems, and the severity of liquidity crises. In a basic framework with a single bank, we find that banks' incentives to hold liquidity for precautionary reasons are increasing with their capital. In a continuum-of-banks setting in which both precautionary and speculative motives of liquidity holdings are taken into account, we find that while the fire-sale discount is decreasing with the capitalisation of the banking system, the link between the latter and the severity of liquidity crises is not monotonic.

Keywords: Leverage, Wholesale Debts, Precautionary Liquidity Holdings, Speculative Liquidity Holdings, Cash-In-The-Market Pricing

JEL Classification: G21, D82

Suggested Citation

Gomez, Fabiana and Vo, Quynh Anh, Liquidity Management, Fire Sales and Liquidity Crises in Banking: The Role of Leverage (March 29, 2019). Available at SSRN: https://ssrn.com/abstract=2696126 or http://dx.doi.org/10.2139/ssrn.2696126

Fabiana Gomez

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, BS8 ITH
United Kingdom

Quynh Anh Vo (Contact Author)

Bank of England ( email )

20 Moorgate
London, EC2R 6DA
United Kingdom

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