Liquidity, Payment and Endogenous Financial Fragility

36 Pages Posted: 6 Mar 2005 Last revised: 4 May 2010

Charles M. Kahn

University of Illinois, Urbana-Champaign; Feseral Reserve Bank of Saint Louis; Bank of Canada

João A. C. Santos

Federal Reserve Bank of New York

Date Written: May 4, 2010

Abstract

We study the fragility of the banking system in relation to its role in liquidity creation. In our framework, fragility stems from the interconnections banks establish to protect themselves from liquidity shocks. In the absence of contractual constraints, banks choose the optimal degree of mutual insurance, because market participants correctly take into account the economic effects of their own interdependence. When banks are in the business of providing liquidity, some contractual flexibility is missing. In this case, we show that banks have an incentive to become too risky in aggregate, since some of the beneficiaries of the liquidity provision are unable to compensate the banks for remaining solvent. We examine possible regulatory remedies for this problem.

Keywords: Systemic risk, liquidity, payment services, bank regulation

JEL Classification: G21, G28

Suggested Citation

Kahn, Charles M. and Santos, João A. C., Liquidity, Payment and Endogenous Financial Fragility (May 4, 2010). EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=680161 or http://dx.doi.org/10.2139/ssrn.680161

Charles M. Kahn

University of Illinois, Urbana-Champaign ( email )

Department of Finance
340 Wohlers Hall
Champaign, IL 61820
United States

HOME PAGE: http://kahnfrance.com/cmk/

Feseral Reserve Bank of Saint Louis

411 Locust St
Saint Louis, MO 63011
United States

Bank of Canada

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

João A. C. Santos (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-5583 (Phone)
212-720-8363 (Fax)

HOME PAGE: HTTP://WWW.NEWYORKFED.ORG/RMAGHOME/ECONOMIST/SANTOS/CONTACT.HTML

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