Liquidity Management, Fire Sale and Liquidity Crises in Banking: The Role of Leverage

43 Pages Posted: 8 Dec 2020

Date Written: December 7, 2020

Abstract

This paper proposes a positive theory of the link between banks’ capitalisation and their liquidity-risk taking as well as the severity of fire-sale problems and liquidity crises. In the basic framework of an individual bank’s decisions, we find that banks’ incentives to hold liquidity for precautionary reason are increasing with their capital. In a continuum-of-banks setting in which both precautionary and speculative motives of liquidity holdings are taken into account, we find that while the fire-sale discount is decreasing with the capitalisation of the banking system, the link between the latter and the severity of liquidity crises is not monotonic.

Keywords: Leverage, Precautionary liquidity holdings, speculative liquidity holdings, wholesale debts, cash-In-the-market pricing

JEL Classification: D82, G21

Suggested Citation

Gomez, Fabiana and Vo, Quynh Anh, Liquidity Management, Fire Sale and Liquidity Crises in Banking: The Role of Leverage (December 7, 2020). Bank of England Working Paper No. 894, Available at SSRN: https://ssrn.com/abstract=3744316 or http://dx.doi.org/10.2139/ssrn.3744316

Fabiana Gomez (Contact Author)

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, BS8 ITH
United Kingdom

Quynh Anh Vo

Bank of England ( email )

20 Moorgate
London, EC2R 6DA
United Kingdom

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