2 Financial Intermediation 1: Banks and liquidity creation

Flashcards on banks and liquidity creation based on lecture notes.

Liquidity and Maturity Transformation

Commercial banks grant loans financed through the issuance of deposits which actively engage in liquidity and maturity transformation of private-sector assets and liabilities.

Liquidity Mismatch

Mismatch of liquidity that arises because bank assets are difficult to sell at their full face value on short notice, and bank liabilities can generally be withdrawn at their full face value on short notice.

Banks as Liquidity Insurance Providers

By pooling individuals’ savings, banks can invest in high return investment projects and concomitantly insure depositors against idiosyncratic liquidity shocks.

Demand for Liquidity

Uncertainty about when to consume and a preference to invest through a bank rather than lending directly.

Financial Markets Role

Agents sell their project to other agents who do not need liquidity, or issue securities to raise liquidity as needed.

Inefficiency of Market Allocation

Arises when agents are highly risk-averse and market imperfections exist; sellers may outnumber buyers, depressing prices.

Banking Role

Banks collect deposits, issue demandable debt (deposit contracts), invest a fraction of deposits in real investment projects, and hold the rest in cash, allowing more efficient risk sharing.

Diamond and Dybvig (DD) Timing

Agents do not know future consumption needs and are either early/impatient or late/patient consumption types.

Autarky

No financial markets, each agent individually chooses the quantity to invest, leading to inefficient allocation as early types liquidate projects

Financial Markets

Markets open at time t = 1, agents can sell future consumption for cash today, improving welfare by avoiding premature liquidation.

Market Efficiency

Early types have illiquid projects but need cash while late types have cash they don't need, early types issue securities to late types and welfare improves.

The Planner’s Problem

There is a unique symmetric Pareto-optimal allocation obtained by maximizing utility subject to resource constraints.

Optimal allocation

As long as U'(1) != RU'(R), the market allocation will be inefficient, and too little (or too much) risk is shared.

Source of Inefficiency

Markets are incomplete because liquidity needs are unobservable, preventing financial contracts conditioned on actual needs.

Financial Intermediation

Banks create liquidity by offering demand deposits, allowing implementation of the first-best allocation; the bank stores π1C∗1 and invests I = 1 − π1C∗1 in illiquid technology.

Fragility and bank run

Another equilibrium exists where all agents withdraw at t = 1 due to a coordination problem; if patient types expect others to withdraw and the bank liquidates entirely, everyone withdraws early.

Theory Outcomes

Fractional banking system improves risk sharing, creating liquidity through asset transformation.

Suspension Convertibility

Banks can decrease incentives to coordinate a run by temporarily halting withdrawals.

Deposit Insurance

Government guarantees deposits up to a certain amount, promoting financial stability.

Borrowing from the Interbank Market

When shocks to banks are idiosyncratic, the interbank market can provide risk-sharing through borrowing.

How Banks Create Liquidity

Banks create liquidity on the balance sheet by financing relatively illiquid assets with relatively liquid liabilities.

Constructing Liquidity Creation Measures: Step 1

Bank assets, liabilities, equity, and off-balance sheet activities are classified as liquid, semi-liquid, or illiquid based on ease and cost.

Constructing Liquidity Creation Measures: Step 2

Weights are assigned to activities classified as liquid, semi-liquid, or illiquid.

Berger and Bouwman (2009)

Step 3: Liquidity creation measures are constructed by combining the activities as classified in step 1 and as weighted in step 2 in different ways.

Example of Liquidity Creation

1 dollar of liquid liabilities is used to fund 1 dollar of illiquid assets.

Bank Value and Liquidity Creation

Is positively correlated with the value of the financial institutions.

Summary

Pool of liquidity, Insurance to households consumption needs, Deposits are used to finance illiquid investments, Source of fragility (bank run)

A modern form of bank run

Fears about banks’ insolvency led creditors to stop rolling over debt and Banks had to liquidate valuable assets at a discount so as not to default on this debt.