The Liquidity of Bank Assets and Banking Stability

24 Pages Posted: 14 Jun 2004

See all articles by Wolf Wagner

Wolf Wagner

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM); Centre for Economic Policy Research (CEPR)

Date Written: December 2004

Abstract

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

Wagner, Wolf, The Liquidity of Bank Assets and Banking Stability (December 2004). Available at SSRN: https://ssrn.com/abstract=556128 or http://dx.doi.org/10.2139/ssrn.556128

Wolf Wagner (Contact Author)

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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