Bank's Liquidity Management and Financial Fragility

CRENOS Working Papers (quaderni di ricerca), 2018

55 Pages Posted: 2 Oct 2019 Last revised: 20 Oct 2019

See all articles by Luca Deidda

Luca Deidda

Università degli Studi di Sassari - Department of Economics and Business; Universita di Cagliari - Centre for North South Economic Research (CRENOS)

Ettore Panetti

affiliation not provided to SSRN

Date Written: 2018

Abstract

We propose a novel theory of banks’ liquidity management and financial fragility. Banks hold liquidity and an illiquid productive asset, thereby engaging in maturity transformation, and insure their depositors against idiosyncratic and aggregate shocks. However, strategic complementarities in the depositors’ withdrawal decisions might trigger a self-fulfilling run, modelled as a “global game”. In equilibrium, if the liquidation of the productive asset is sufficiently costly and the depositors are sufficiently risk averse, banks manage their liquidity needs during runs following an endogenous pecking order: they first deplete liquidity, and then liquidate the productive asset. Thus, under these conditions banks subject to runs are first illiquid but solvent, and then become insolvent. Ex ante, if the probability of the idiosyncratic shock is sufficiently large, banks hoard liquidity, and narrow banking is not viable.

Keywords: banks, liquidity, financial fragility, self-fulfilling runs, global games, narrow banking

JEL Classification: G01, G21, G28

Suggested Citation

Deidda, Luca and Panetti, Ettore, Bank's Liquidity Management and Financial Fragility (2018). CRENOS Working Papers (quaderni di ricerca), 2018, Available at SSRN: https://ssrn.com/abstract=3459445 or http://dx.doi.org/10.2139/ssrn.3459445

Luca Deidda (Contact Author)

Università degli Studi di Sassari - Department of Economics and Business ( email )

via Muroni 25
Sassari, Sassari 07100
Italy

Universita di Cagliari - Centre for North South Economic Research (CRENOS) ( email )

Italy

Ettore Panetti

affiliation not provided to SSRN

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