Abstract
Banks hold large amounts of high-quality liquid assets while relying predominantly on deposit funding. The return on these assets is often lower than the cost of deposits. Why do banks engage in such a negative carry trade? Using a novel observation on global games, we build a tractable model where banks manage liquidity risk by adjusting the size of their short-term liabilities and of their liquid reserves consisting of safe, liquid government bonds. Banks are the natural buyers of government bonds because holding these assets enables them to multiply liquidity'': using one unit of bonds to back more than one unit of short-term debt while keeping their liquidity risk unchanged. How much more is measured by the slope of an endogenous iso-risk curve. This liquidity multiplier is key to understand a bank's joint choice of leverage and liquid reserves and how these decisions connect to the pricing of liquid assets. In turn, this provides an explanation of the negative carry puzzle.
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
