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Outside and Inside Liquidity

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  • Patrick Bolton
  • Tano Santos
  • Jose A. Scheinkman

Abstract

We propose an origination-and-contingent-distribution model of banking, in which liquidity demand by short-term investors (banks) can be met with cash reserves (inside liquidity) or sales of assets (outside liquidity) to long-term investors (hedge funds and pension funds). Outside liquidity is a more efficient source, but asymmetric information about asset quality can introduce a friction in the form of excessively early asset trading in anticipation of a liquidity shock, excessively high cash reserves, and too little origination of assets by banks. The model captures key elements of the financial crisis and yields novel policy prescriptions. Copyright 2011, Oxford University Press.

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Bibliographic Info

Article provided by Oxford University Press in its journal The Quarterly Journal of Economics.

Volume (Year): 126 (2011)
Issue (Month): 1 ()
Pages: 259-321

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Handle: RePEc:oup:qjecon:v:126:y:2011:i:1:p:259-321

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  1. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
  2. James Dow & Gary Gorton, 1993. "Arbitrage Chains," CEPR Financial Markets Paper, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ 0035, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
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  6. Freixas, Xavier & Parigi, Bruno & Rochet, Jean Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers 2325, C.E.P.R. Discussion Papers.
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  8. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  10. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  11. Péter Kondor, 2009. "Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading," Journal of Finance, American Finance Association, American Finance Association, vol. 64(2), pages 631-655, 04.
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