Banks' Liquidity Management and Systemic Risk

Abstract

We study a novel mechanism through which systemic risk, in the form of self-fulfilling runs, forces the banks to hoard liquidity. To this end, we develop an environment where banks offer insurance to their depositors against both idiosyncratic and aggregate real uncertainty, by holding a portfolio of liquidity and productive illiquid assets. Moreover, banks’ asset portfolios and the probability of a depositors’ self-fulfilling run are jointly determined via a “global game”. In equilibrium, an endogenous pecking order emerges: if the recovery rate associated with early liquidation of the productive assets is sufficiently low and the depositors are sufficiently risk averse, the banks first employ liquidity and then liquidate the productive asset, in order to finance depositors’ withdrawals. Ex ante, the banks hold more liquidity than in a full-information economy, where there are no self-fulfilling runs and risk is only due to idiosyncratic and aggregate real uncertainty.