Abstract
This article presents a model of market-liquidity provision by deposit-taking banks. Access to low-cost debt funding induces banks to lever up; this strengthens their willingness to absorb risk, counteracting liquidity-provision frictions and moving asset prices closer to fundamentals. However, liquidity provision may also overshoot, leading to unhealthy price bubbles and causing ex ante asset origination to become excessive. Capital requirements and actuarially fair pricing of guarantees for bank debt are no panacea: They can spur risk taking and make bubbles bubblier. Ring fencing of trading activities can be, but is not necessarily, desirable.
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