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
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: Suggested Citation