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Credit Market Competition and Liquidity Crises

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  • Elena Carletti
  • Agnese Leonello
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    Abstract

    We develop a model where banks invest in reserves and loans, and face aggregate liquidity shocks. Banks with liquidity shortage sell loans on the interbank market. Two equilibria emerge. In the no default equilibrium, all banks hold enough reserves and remain solvent. In the mixed equilibrium, some banks default with positive probability. The former exists when credit market competition is intense. The latter emerges when banks exercise market power. Thus, competition is beneficial to financial stability. The structure of liquidity shocks affects the severity and the occurrence of crises, as well as the amount of credit available in the economy.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2014/wp-cesifo-2014-02/cesifo1_wp4647.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 4647.

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    Date of creation: 2014
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    Handle: RePEc:ces:ceswps:_4647

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    Keywords: interbank market; default; price volatility;

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    1. Carletti, Elena & Hartmann, Philipp & Spagnolo, Giancarlo, 2005. "Bank Mergers, Competition and Liquidity," Working Paper Series 182, Sveriges Riksbank (Central Bank of Sweden).
    2. Allen, Franklin & Carletti, Elena & Gale, Douglas, 2009. "Interbank market liquidity and central bank intervention," Journal of Monetary Economics, Elsevier, Elsevier, vol. 56(5), pages 639-652, July.
    3. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2009. "Crisis Resolution and Bank Liquidity," NBER Working Papers 15567, National Bureau of Economic Research, Inc.
    4. Jean-Charles Rochet & Xavier Vives, 2002. "Coordination failures and the lender of last resort: was Bagehot right after all?," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 24928, London School of Economics and Political Science, LSE Library.
    5. Allen N. Berger & Christa H. S. Bouwman, 2009. "Bank Liquidity Creation," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(9), pages 3779-3837, September.
    6. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
    7. Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 2-92, Wharton School - Weiss Center for International Financial Research.
    8. Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
    9. T. Beck & O. De Jonghe & G. Schepens, 2011. "Bank competition and stability: cross-country heterogeneity," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium, Ghent University, Faculty of Economics and Business Administration 11/732, Ghent University, Faculty of Economics and Business Administration.
    10. Matutes, Carmen & Vives, Xavier, 1996. "Competition for Deposits, Fragility, and Insurance," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 5(2), pages 184-216, April.
    11. Allen, Franklin & Carletti, Elena, 2008. "Mark-to-market accounting and liquidity pricing," Journal of Accounting and Economics, Elsevier, Elsevier, vol. 45(2-3), pages 358-378, August.
    12. Douglas W. Diamond & Raghuram G. Rajan, 2011. "Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes," The Quarterly Journal of Economics, Oxford University Press, vol. 126(2), pages 557-591.
    13. John H. Boyd & Gianni De Nicolã, 2005. "The Theory of Bank Risk Taking and Competition Revisited," Journal of Finance, American Finance Association, American Finance Association, vol. 60(3), pages 1329-1343, 06.
    14. Itay Goldstein & Ady Pauzner, 2005. "Demand-Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, American Finance Association, vol. 60(3), pages 1293-1327, 06.
    15. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, American Economic Association, vol. 80(5), pages 1183-1200, December.
    16. Xavier Freixas & José Jorge, 2007. "The role of interbank markets in monetary policy: A model with rationing," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1027, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2008.
    17. Boyd, John H & De Nicolo, Gianni & Smith, Bruce D, 2004. "Crises in Competitive versus Monopolistic Banking Systems," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 36(3), pages 487-506, June.
    18. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
    19. David Martinez-Miera & Rafael Repullo, 2010. "Does Competition Reduce the Risk of Bank Failure?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 23(10), pages 3638-3664, October.
    20. Viral Acharya & Tanju Yorulmazer, 2007. "Cash-in-the-market pricing and optimal resolution of bank failures," Bank of England working papers, Bank of England 328, Bank of England.
    21. Fabio Castiglionesi, 2013. "Financial Intermediation and Liquidity," Rivista di Politica Economica, SIPI Spa, SIPI Spa, issue 1, pages 7-36, January-M.
    22. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(1), pages 89-111, January.
    23. Gianni De Nicolò & Marcella Lucchetta, 2013. "Bank Competition and Financial Stability: A General Equilibrium Exposition," CESifo Working Paper Series 4123, CESifo Group Munich.
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