The Liquidity of Bank Assets and Banking Stability
24 Pages Posted: 14 Jun 2004
Date Written: December 2004
The emerging markets for credit derivatives have improved the liquidity of bank assets by providing banks with various new possibilities for selling and hedging their risks. This paper examines the consequences for banking stability. In a simple model where liquidation of bank assets is costly, we show that increased asset liquidity benefits stability by encouraging a representative bank to reduce the risks on its balance sheet. Stability is further enhanced because the bank can now liquidate assets in a crisis more easily. However, these effects are counteracted by increased risk-taking of the bank. We find that overall, stability actually falls. This is because the improved possibilities for liquidating assets in a crisis make a crisis less costly for the bank, which induces the bank to take on an amount of risk that more than offsets the initial positive impact on stability.
Keywords: Financial innovations, credit derivatives, risk taking, bank default, asset liquidity
JEL Classification: G21, G28
Suggested Citation: Suggested Citation