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Liquidity, Moral Hazard and Inter-Bank Market Collapse

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  • Kharroubi, E.
  • Vidon E.

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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Bibliographic Info

Paper provided by Banque de France in its series Working papers 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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Keywords: Liquidity Crisis ; Moral Hazard ; Interbank Market ; Competition;

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References

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Cited by:
  1. Sören Radde, 2012. "Flight-to-Liquidity and the Great Recession," Discussion Papers of DIW Berlin 1242, DIW Berlin, German Institute for Economic Research.
  2. 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.

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