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Liquidity, Moral Hazard and Inter-Bank Market Collapse

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Author Info
Kharroubi, E.
Vidon E.

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Abstract

This paper proposes a framework to analyze the functioning of the inter-bank liquidity market and the occurrence of liquidity crises. The model relies on three key assumptions: (i) liquidity provisioning 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-, (iii) liquidity shocks are private information - they cannot be diversified away-. Under these assumptions, the equilibrium risk-adjusted return on liquidity provisioning increases with the aggregate equilibrium volume of ex ante liquidity provision. As a consequence, banks may provision too little liquidity compared with the social optimum. Within this framework we derive two main results. First inter-bank market collapse is an equilibrium. Second such an equilibrium is more likely when (i) the individual probability of the liquidity shock is lower, (ii) ex ante competition between banks on illiquid long term assets is larger.

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Publisher Info
Paper provided by Banque de France in its series Documents de Travail with number 227.

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Length: 39 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:bfr:banfra:227

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Related research
Keywords: Liquidity Crisis ; Moral Hazard ; Interbank Market ; Competition;

Find related papers by JEL classification:
D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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