Liquidity Hoarding and Inefficient Abundant Funding

This paper studies banks’ choice between building liquidity buffers and raising funding ex post to deal with reinvestment shocks. We uncover the possibility of an inefficient liquidity squeeze equilibrium when ex post funding is abundant. In the model, banks typically build larger liquidity buffers when they expect funding to be expensive. However, when banks hold larger liquidity buffers, pledgeable income is larger and they hence can raise more funding, which in the aggregate raises the funding cost. This feedback loop between liquidity hoarding and the cost of ex post funding yields multiple equilibria, one being an inefficient liquidity squeeze equilibrium where banks do not build any liquidity buffer. Comparative statics show that this inefficient equilibrium is more likely when the supply of ex post funding is large. Last, in this equilibrium, a “borrower”-of-last-resort policy can improve social welfare if drying up ex post funding restores bank incentives to hold liquidity ex ante.