Banking crises and liquidity in a monetary economy (original) (raw)

Banking Panics and Liquidity in a Monetary Economy

SSRN Electronic Journal

This paper studies banks' liquidity provision in the Lagos and Wright model of monetary exchanges. With aggregate uncertainty we show that banks sometimes exhaust their cash reserves and fail to satisfy their depositors' need of consumption smoothing. The banking panics can be eliminated by the zero-interest policy for the perfect risk sharing, but the first best can be achieved only at the Friedman rule. In our monetary equilibrium, the probability of banking panics is endogenous and increases with inflation, as is consistent with empirical evidence. The model derives a rich array of non-trivial effects of inflation on the equilibrium deposit and the bank's portfolio.

Bank Liquidity, Interbank Markets, and Monetary Policy

Review of Financial Studies, 2011

A major lesson of the recent …nancial crisis is that the interbank lending market is crucial for banks facing large uncertainty regarding their liquidity needs. This paper studies the e¢ ciency of the interbank lending market in allocating funds. We consider two di¤erent types of liquidity shocks leading to di¤erent implications for optimal policy by the central bank. We show that, when confronted with a distributional liquidity-shock crisis that causes a large disparity in the liquidity held among banks, the central bank should lower the interbank rate. This view implies that the traditional tenet prescribing the separation between prudential regulation and monetary policy should be abandoned. In addition, we show that, during an aggregate liquidity crisis, central banks should manage the aggregate volume of liquidity. Two di¤erent instruments, interest rates and liquidity injection, are therefore required to cope with the two di¤erent types of liquidity shocks. Finally, we show that failure to cut interest rates during a crisis erodes …nancial stability by increasing the risk of bank runs.

Money in the Equilibrium of Banking

SSRN Electronic Journal, 2015

In most banking models, money is merely modeled as medium for transaction, but in reality, money is also the most liquid asset for banks. Central banks do not only passively supply money to meet demand for transaction, as often assumed in these models, instead they also actively inject liquidity into market, taking banks' illiquid assets as collateral. We examine both roles of money in an integrated framework, in which banks are subject to aggregate illiquidity risk. With fixed nominal deposit contracts, the monetary economy with active central bank can replicate constrained efficient allocation. This allocation, however, cannot be implemented in market equilibrium without additional regulation: Due to moral hazard problems, banks invest excessively in illiquid assets, forcing the central bank to provide liquidity at low interest rates. We show that interest rate policy to reduce systemic liquidity risk on its own is dynamically inconsistent. Instead, the constrained efficient solution can be achieved by imposing ex ante liquidity coverage requirement.

Liquidity, Money Creation and Destruction, and the Returns to Banking*

International Economic Review, 2005

We build on our earlier model of money in which bank liabilities circulate as a medium of exchange. We investigate optimal bank behavior and the resulting provision of liquidity under a range of central bank regulations. In our model, banks issue inside money under fractional reserves, facing the possibility of excess redemptions. Banks consider the float resulting from money creation and make reserve-management decisions that affect aggregate liquidity conditions. Numerical examples demonstrate positive bank failure rates when returns to banking are low. Central bank interventions may improve banks' returns and welfare through a reduction in bank failure.

Interbank exchanges, liquidity management and banking crises

2001

In a theoretical framework where liquidity crises are not only caused by bank runs, and where there is uncertainty about the proportion of depositors who may want to withdraw deposits, we show that abandoning the hypothesis of a representative bank (as in Diamond and ...

Liquidity Shortages and Monetary Policy

Monetary Economics, 2008

The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we con...

Incomplete Deposit Contracts , Banking Crises , and Monetary Policy ∗

2014

Money plays important roles in modern financial systems. This study develops a banking model comprising monetary factors in order to investigate the relationship between money and banking crises. In the model, it is assumed that banking deposit contracts are not contingent on the state of nature. We show that under incomplete contracts, a banking crisis may occur when inflation is sufficiently low or high. The result appears to be consistent with empirical evidence. We also show that the zero-inflation policy can be optimal under either complete or incomplete banking contracts, despite the Friedman rule eliminating the possibility of crises.

Banks and markets in a monetary economy

Journal of Monetary Economics, 2008

Modern financial sectors consist of banks, asset markets and a central bank. This paper builds a model where these institutions provide different financial services, and their interaction supports efficient allocations. When one institution is missing equilibria are, by construction, inefficient. The paper analyzes how interest rates and asset prices depend on the structure of the financial sector and characterizes the central bank policy that supports efficient allocations. The analysis relies on the difference between liquidity and real shocks, and relates the notion of liquidity used in this paper to the one adopted in other studies.