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

Posted: 13 May 2019 Last revised: 21 Mar 2021

See all articles by Demian Nicolás Macedo

Demian Nicolás Macedo

University of the Balearic Islands

Victor Emilio Troster

affiliation not provided to SSRN

Date Written: March 11, 2019

Abstract

Banks may be reluctant to remove bad loans from their portfolios during liquidity shortfalls, giving rise to a moral hazard problem. In this paper, we analyze how liquidity shortages 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 to a cash-flow shock (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 nonperforming loans has more adverse effects on balance sheets than a deposit flight. We also demonstrate that competition has a dual effect on financial stability. Interbank competition enhances financial stability by reducing the liquidity provision cost, whereas credit market competition worsens financial stability by inducing banks to take riskier profiles.

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

JEL Classification: G00, G01, G21,D82

Suggested Citation

Macedo, Demian and Troster, Victor Emilio, Liquidity Shocks and Interbank Market Failures: The Role of Deposit Flights, Non-Performing Loans, and Competition (March 11, 2019). Available at SSRN: https://ssrn.com/abstract=3350684 or http://dx.doi.org/10.2139/ssrn.3350684

Demian Macedo (Contact Author)

University of the Balearic Islands ( email )

Crtra. Valldemossa, km 7.5
Ed. Ramon Llull
Palma de Mallorca, Illles Balears 07122
Spain

Victor Emilio Troster

affiliation not provided to SSRN

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