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Journal of Economic Interaction and Coordination

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21-03-2021 | Regular Article

Liquidity shocks and interbank market failures: the role of deposit flights, non-performing loans, and competition

Authors: Demian Macedo, Victor Troster

Published in: Journal of Economic Interaction and Coordination | Issue 4/2021

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Abstract

Banks may be reluctant to remove bad loans from their portfolios during liquidity shortfalls, giving rise to a moral hazard problem. In this paper, we analyze how liquidity shortages affect the ability of the interbank market to provide liquidity in a moral hazard setting. We distinguish two types of liquidity shocks that arise due to a deposit flight (a contraction in the deposit supply) or to a cash-flow shock (an increase in the non-performing loans). We show that the source of a liquidity shortfall is the main determinant of the decision of banks to stop lending in the interbank market, rather than the extra amount of funds that banks need to cover. An increase in the non-performing loans has more adverse effects on balance sheets than a deposit flight. We also demonstrate that competition has a dual effect on financial stability. Interbank competition enhances financial stability by reducing the liquidity provision cost, whereas credit market competition worsens financial stability by inducing banks to take riskier profiles.

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The literature provides evidence of this behavior during a financial crisis (Sheng 1996; Gunther and Moore 2003; Niinimaki 2012). Banks may be reluctant to remove bad loans from their portfolio because they face a reputational cost, and a bad reputation worsens their funding conditions in the market (Gabrieli 2011). Further, banks restructuring their portfolios may have to sell their assets at fire-sale prices, leading to considerable losses for their shareholders (Diamond and Rajan 2011).

Banks A and B are monopolists in their own deposit markets, and the depositors’ utility of consuming at \(t = 0\) is null. Then, it follows that \(r_{0} = 1\).

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Title: Liquidity shocks and interbank market failures: the role of deposit flights, non-performing loans, and competition
Authors: Demian Macedo
Victor Troster
Publication date: 21-03-2021
Publisher: Springer Berlin Heidelberg
Published in: Journal of Economic Interaction and Coordination / Issue 4/2021
Print ISSN: 1860-711X
Electronic ISSN: 1860-7128
DOI: https://doi.org/10.1007/s11403-021-00326-5

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