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

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