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A Theory of Bank Illiquidity and Default with Hidden Trades

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  • Panetti, Ettore

Abstract

I develop a theory of financial intermediation to explore how the availability of trading opportunities affects the link between the liquidity of financial institutions and their default decisions. In it, banks hedge against liquidity shocks either in the interbank market or by using a costly bankruptcy procedure, and depositors trade in the asset market without being observed. In this environment, the competitive pressure from the asset markets makes intermediaries choose an illiquid asset portfolio. I prove three results. First, illiquid banks default in equilibrium only when there is systemic risk and an unpredicted crisis hits the economy. Second, in contrast to the previous literature, the allocation at default is not socially optimal. Third, the constrained efficient allocation can be decentralized with the introduction of countercyclical liquidity requirements.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 43799.

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Date of creation: Nov 2011
Date of revision: May 2012
Handle: RePEc:pra:mprapa:43799

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Related research

Keywords: Financial intermediation; bankruptcy; liquidity; hidden trades; insurance; optimal regulation;

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References

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  1. von Thadden, Ernst-Ludwig, 1999. "Liquidity creation through banks and markets: Multiple insurance and limited market access," European Economic Review, Elsevier, vol. 43(4-6), pages 991-1006, April.
  2. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2006. "A Theory of Liquidity and Regulation of Financial Intermediation," Levine's Bibliography 321307000000000326, UCLA Department of Economics.
  3. Marie Hoerova & Cornelia Holthausen & Florian Heider, 2009. "Liquidity hoarding and interbank market spreads: the role of counterparty risk," 2009 Meeting Papers 929, Society for Economic Dynamics.
  4. Xavier Freixas & José Jorge, 2007. "The role of interbank markets in monetary policy: A model with rationing," Economics Working Papers 1027, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2008.
  5. Mikhail Golosov & Aleh Tsyvinski, 2006. "Optimal Taxation with Endogenous Insurance Markets," Levine's Bibliography 784828000000000445, UCLA Department of Economics.
  6. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-56, October.
  7. Pricila Maziero, 2009. "Non-Exclusive Dynamic Contracts, Competition, and the Limits of Insurance," 2009 Meeting Papers 509, Society for Economic Dynamics.
  8. Panetti, Ettore, 2011. "Financial liberalization and contagion with unobservable savings," MPRA Paper 29540, University Library of Munich, Germany.
  9. Hui Chen, 2010. "Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure," Journal of Finance, American Finance Association, vol. 65(6), pages 2171-2212, December.
  10. Antinolfi, Gaetano & Prasad, Suraj, 2008. "Commitment, banks and markets," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 265-277, March.
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