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Liquidity, Moral Hazard, and Interbank Market Collapse

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  • Enisse Kharroubi

    (Banque de France)

  • Edouard Vidon

    (International Monetary Fund)

Abstract

This paper proposes a framework to analyze the functioning of the interbank liquidity market and the occurrence of liquidity crises. The model relies on three key assumptions: (i) ex ante investment in liquid assets is not verifiable - it cannot be contracted upon, (ii) banks face moral hazard when confronted with liquidity shocks - unobservable effort can help overcome the shock, and (iii) liquidity shocks are private information - they cannot be diversified away. Under these assumptions, the aggregate volume of capital invested in liquid assets is shown to exert a positive externality on individual decisions to hoard liquid assets. Due to this property, the collapse of the interbank market for liquidity is an equilibrium. Moreover, such an equilibrium is more likely when the individual probability of the liquidity shock is lower. Banks may therefore provision too few liquid assets compared with the social optimum.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 5 (2009)
Issue (Month): 4 (December)
Pages: 51-86

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Handle: RePEc:ijc:ijcjou:y:2009:q:4:a:3

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Cited by:
  1. Radde, Sören, 2012. "Liquidity Crises, Banking, and the Great Recession," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 65408, Verein für Socialpolitik / German Economic Association.
  2. Sören Radde, 2012. "Flight-to-Liquidity and the Great Recession," Discussion Papers of DIW Berlin 1242, DIW Berlin, German Institute for Economic Research.

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