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Inside Liquidity in Competitive Markets

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  • Michiel Bijlsma

    ()

  • Andrei Dubovik

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  • Gijsbert Zwart

    ()

Abstract

In CPB Discussion Paper 209 we study incentives of financial intermediaries to reserve liquidity given that they can rely on the interbank market for their liquidity needs. Intermediaries can partially pledge their assets to each other, but not to the rest of the economy. Therefore liquidity provision is endogenous. We show that if the probability of a crisis is large or if assets are slightly pledgeable, then all intermediaries reserve liquidity. However, if the probability of a crisis is small or if assets are highly pledgeable, then intermediaries segregate ex ante: some reserve no liquidity, others reserve to the maximum and become liquidity providers. This segregation arises, because in the latter case the crisis short-term rate exceeds the returns on long-term investments, while at the same time higher liquidity holdings also increase survival probability. Together, these two effects result in increasing marginal returns to liquidity in the crisis state, and, consequently, segregation ex ante. In either equilibrium, aggregate liquidity is too small if assets are not fully pledgeable. Minimum liquidity requirements only improve welfare in the symmetric equilibrium. Marginally lowering the interest rate causes a marginal crowding-out of private liquidity with public liquidity in the symmetric equilibrium, but a full crowding-out in the asymmetric equilibrium.

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Paper provided by CPB Netherlands Bureau for Economic Policy Analysis in its series CPB Discussion Paper with number 209.

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Date of creation: Apr 2012
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Handle: RePEc:cpb:discus:209

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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. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  3. Holmström, Bengt, 2013. "Inside and Outside Liquidity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262518536, December.
  4. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
  5. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  6. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  7. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-55, September.
  8. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  9. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  10. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
  11. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
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