Government Debt and Bank Leverage Cycle: An Analysis of Public and Intermediated Liquidity
Charles A. Dice Center Working Paper No. 2017-24
61 Pages Posted: 25 Oct 2017 Last revised: 20 Aug 2020
Date Written: August 19, 2020
Financial intermediaries issue the majority of liquid securities, and nonfinancial firms have become net savers, holding intermediaries' debt as cash. This paper shows that intermediaries' liquidity creation stimulates growth -- firms hold their debt for unhedgeable investment needs -- but also breeds instability through procyclical intermediary leverage. Introducing government debt as a competing source of liquidity is a double-edged sword: firms hold more liquidity in every state of the world, but by squeezing intermediaries' profits and amplifying their leverage cycle, public liquidity increases the frequency and duration of intermediation crises, raising the likelihood of states with less liquidity supplied by intermediaries. The latter force dominates and the overall impact of public liquidity is negative, when public liquidity cannot satiate firms' liquidity demand and intermediaries are still needed as the marginal liquidity suppliers.
Keywords: Inside money, liquidity management, procyclical leverage, government debt, slow recovery, intertemporal feedback
JEL Classification: E02, E22, E32, E41, E43, E44, E51, E58, E61, E62, G01, G12, G18, G20, G30
Suggested Citation: Suggested Citation