Money market derivatives and the allocation of liquidity risk in the banking sector

Falko Fecht () and Hendrik Hakenes ()

No 2006,12, Discussion Paper Series 2: Banking and Financial Studies from Deutsche Bundesbank, Research Centre

Abstract: Money markets have two functions, the allocation of liquidity and the processing of information. We develop a model that allows us to evaluate the efficiency of different money market derivatives regarding these two objectives. We assume that due to its size, a large bank receives a more precise signal about the overall liquidity development in the banking sector. In an upcoming liquidity shortage this large bank can exploit its informational advantage in the spot money market by rationing liquidity. Using forward contracts, the large bank can credibly commit not to squeeze small banks in the event of a liquidity shortage. But forward contracts do not provide incentives for the large bank to pass on its information to other banks. In contrast, lines of credit between the large and the small banks ensure that the large bank provides its information to other banks.

Keywords: Liquidity; money market derivatives; lines of credit; forward contracts; options (search for similar items in EconPapers)
JEL-codes: D82 G21 G33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-mon
Date: 2006
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