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