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Banks, Markets, and Financial Stability

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  • Fecht, Falko
  • Eder, Armin
  • Pausch, Thilo

Abstract

In a theoretical model of the Diamond-Dybvig style, in which deposit-taking banks and financial markets coexist, bank behavior is analyzed taking into account a positive ex-ante probability of a future financial crisis. We focus on the role of the interaction of market liquidity and banks' funding liquidity in the propagation of shocks in the financial system. Our findings suggest that in particular bank-dominated financial systems are prone to contagious bank runs due to asset price deteriorations as a consequence of fire sales of assets in financial markets. Nevertheless, banks only prefer holding liquidity buffers to weather future crises if the ex-ante crisis probability exceeds a certain threshold. Moreover, central bank interventions are shown to have destabilizing effects because they reduce banks' incentives to hold liquidity buffers. This can be interpreted as a justification for prudential regulation in terms of minimum liquidity buffer requirements. --

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Paper provided by Verein für Socialpolitik / German Economic Association in its series Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order with number 79712.

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Date of creation: 2013
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Handle: RePEc:zbw:vfsc13:79712

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  1. Douglas Gale & Tanju Yorulmazer, 2011. "Liquidity hoarding," Staff Reports, Federal Reserve Bank of New York 488, Federal Reserve Bank of New York.
  2. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 109(2), pages 287-327, April.
  3. Huang, Jennifer & Wang, Jiang, 2010. "Market liquidity, asset prices, and welfare," Journal of Financial Economics, Elsevier, Elsevier, vol. 95(1), pages 107-127, January.
  4. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports, Federal Reserve Bank of New York 328, Federal Reserve Bank of New York.
  5. Viral V. Acharya & S. Viswanathan, 2010. "Leverage, Moral Hazard and Liquidity," NBER Working Papers 15837, National Bureau of Economic Research, Inc.
  6. Allen, Franklin & Carletti, Elena, 2006. "Mark-to-market accounting and liquidity pricing," CFS Working Paper Series 2006/17, Center for Financial Studies (CFS).
  7. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 105(5), pages 928-56, October.
  8. Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
  9. Falko Fecht, 2003. "On the Stability of Different Financial Systems," Working Paper Series: Finance and Accounting, Department of Finance, Goethe University Frankfurt am Main 110, Department of Finance, Goethe University Frankfurt am Main.
  10. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, Elsevier, vol. 41(1), pages 27-38, February.
  11. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, American Finance Association, vol. 60(2), pages 615-647, 04.
  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  13. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers, Financial Markets Group dp580, Financial Markets Group.
  14. Holmstrom, Bengt & Tirole, Jean, 2000. "Liquidity and Risk Management," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 32(3), pages 295-319, August.
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