Government Debt and Bank Leverage Cycle: An Analysis of Public and Intermediated Liquidity

61 Pages Posted: 25 Oct 2017 Last revised: 20 Aug 2020

See all articles by Ye Li

Ye Li

Ohio State University

Date Written: August 19, 2020

Abstract

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

Li, Ye, Government Debt and Bank Leverage Cycle: An Analysis of Public and Intermediated Liquidity (August 19, 2020). Fisher College of Business Working Paper No. 2017-03-24, Columbia Business School Research Paper No. 17-106, Charles A. Dice Center Working Paper No. 2017-24, Available at SSRN: https://ssrn.com/abstract=3057997 or http://dx.doi.org/10.2139/ssrn.3057997

Ye Li (Contact Author)

Ohio State University ( email )

Fisher Hall 836, 2100 Neil Ave
Columbus, OH 43210
United States

HOME PAGE: http://yeli-macrofinance.com

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