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Banks, Markets, and Financial Stability

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

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. Itay Goldstein & Ady Pauzner, 2005. "Demand-Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, 06.
  2. Falko Fecht, 2003. "On the Stability of Different Financial Systems," Finance 0305008, EconWPA.
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  4. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank Liquidity, Interbank Markets and Monetary Policy," Working Papers 429, Barcelona Graduate School of Economics.
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  8. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
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  13. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  14. Huang, Jennifer & Wang, Jiang, 2010. "Market liquidity, asset prices, and welfare," Journal of Financial Economics, Elsevier, vol. 95(1), pages 107-127, January.
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  17. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-56, October.
  18. Denis Gromb & Dimitri Vayanos, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," LSE Research Online Documents on Economics 448, London School of Economics and Political Science, LSE Library.
  19. Huberto M. Ennis & Todd Keister, 2003. "Government Policy and the Probability of Coordination Failures," Working Papers 0301, Centro de Investigacion Economica, ITAM.
  20. Patrick Bolton & Tano Santos & Jose A. Scheinkman, 2011. "Outside and Inside Liquidity," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 259-321.
  21. Gale, Douglas & Yorulmazer, Tanju, 2013. "Liquidity hoarding," Theoretical Economics, Econometric Society, vol. 8(2), May.
  22. Holmstrom, Bengt & Tirole, Jean, 2000. "Liquidity and Risk Management," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 295-319, August.
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