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

46 Pages Posted: 13 May 2019 Last revised: 14 Jun 2019

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 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

Suggested Citation

Macedo, Demian and Troster, Victor Emilio, Liquidity Shocks and Interbank Market Failures: The Role of Deposit Flights, Non-Performing Loans, and Credit Market 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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