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Banks' Liquidity Management and Systemic Risk

Ettore Panetti and Luca Deidda ()

Working Paper CRENoS from Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia

Abstract: We study a novel mechanism to explain the interaction between banks' liquidity management and the emergence of systemic financial crises, in the form of self-fulfilling runs. To this end, we develop an environment where banks offer insurance to their depositors against both idiosyncratic and aggregate real shocks, by holding a portfolio of liquidity and illiquid productive assets. Moreover, banks' asset portfolios and the probability of a depositors' self-fulfilling run are jointly determined via a "global game". We characterize the sufficient conditions under which there exists a unique threshold recovery rate, associated with the early liquidation of the productive assets, below which the banks first employ liquidity and then liquidate, in order to finance depositors' early withdrawals. Ex ante, the banks hold more liquidity than in a full-information economy, where there are no self-fulfilling runs and risk is only due to idiosyncratic and aggregate real shocks.

Keywords: systemic risk; global games; excess liquidity; bank runs (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-rmg
Date: 2017
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