Liquidity Moral Hazard and Interbank Market Collapse

<p>This paper proposes a framework to analyze the functioning of the interbank liquidity market and the occurrence of liquidity crises. The model relies on three key assumptions: (i) ex ante investment in liquid assets is not verifiable - it cannot be contracted upon (ii) banks face moral hazard when confronted with liquidity shocks - unobservable effort can help overcome the shock and (iii) liquidity shocks are private information - they cannot be diversified away. Under these assumptions the aggregate volume of capital invested in liquid assets is shown to exert a positive externality on individual decisions to hoard liquid assets. Due to this property the collapse of the interbank market for liquidity is an equilibrium. Moreover such an equilibrium is more likely when the individual probability of the liquidity shock is lower. Banks may therefore provision too few liquid assets compared with the social optimum.</p><p>This work has been selected by scholars as being culturally important and is part of the knowledge base of civilization as we know it. This work was reproduced from the original artifact and remains as true to the original work as possible. Therefore you will see the original copyright references library stamps (as most of these works have been housed in our most important libraries around the world) and other notations in the work.</p><p>This work is in the public domain in the United States of America and possibly other nations. Within the United States you may freely copy and distribute this work as no entity (individual or corporate) has a copyright on the body of the work.</p><p>As a reproduction of a historical artifact this work may contain missing or blurred pages poor pictures errant marks etc. Scholars believe and we concur that this work is important enough to be preserved reproduced and made generally available to the public. We appreciate your support of the preservation process and thank you for being an important part of keeping this knowledge alive and relevant.</p><br>