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Liquidity, Payment and Endogenous Financial Fragility

Charles M. Kahn

University of Illinois, Urbana-Champaign

João A. C. Santos

Federal Reserve Bank of New York

May 4, 2010

EFA 2005 Moscow Meetings Paper

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.

Number of Pages in PDF File: 36

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

JEL Classification: G21, G28

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Date posted: March 6, 2005 ; Last revised: May 4, 2010

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

Contact Information

Charles M. Kahn
University of Illinois, Urbana-Champaign ( email )
Department of Finance
340 Wohlers Hall
Champaign, IL 61820
United States
217-333-2813 (Phone)
HOME PAGE: http://kahnfrance.com/cmk/
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)
Feedback to SSRN

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