Liquidity Shocks and Interbank Market Failures: The Role of Deposit Flights, Non-Performing Loans, and Credit Market Competition

Abstract

Banks may be reluctant to remove bad loans from their portfolio during liquidity shortfalls, giving rise to a moral hazard problem in the interbank market. This paper develops a model to analyze how liquidity shortfalls can affect the ability of the interbank market to provide liquidity in a moral hazard setting. We distinguish two types of liquidity shocks that arise due to a deposit flight (a contraction in the deposit supply) or a cash-flow shock (a reduction in the cash collection due to an increase in the non-performing loans). We show that the source of a liquidity shortfall is the main determinant of the decision of banks to stop lending in the interbank market, rather than the extra amount of funds that banks need to cover. An increase in the non-performing loans has more adverse effects on balance sheets than a deposit flight. We also find that credit market competition increases financial instability not only by undermining the role of the interbank market as a liquidity provider but also by exacerbating liquidity shortfalls.

Keywords: Liquidity shocks; Interbank market; Deposit flights; Non-performing loans; Credit market competition; Moral hazard

JEL Classification: G00, G01, G21,D82