The Cost of Capital in Markets with Opaque Intermediaries and the Risk-Structure of Interest Rates

Abstract

The demand for cash balances of financial intermediaries that establish contractual liabilities with credit-sensitive customers is characterised. As stated by Merton, the success of the business activities of such firms crucially depends on their credit quality, and hence, they are obliged to rely on deposit insurance and capital cushions in order to assure that their promised payments are free of default. Unlike the Merton’s approach, the optimal guaranteeing contract is formulated in actuarial terms in this paper, because in this way the model can be extended to consider the situation of firms that can only hedge up to a limited extent. Within this framework, the equilibrium in the market determines the rate at which a unit of capital is exchange by a unit of risk, or, in other words, it determines the market price of risk. Episodes of liquidity crises are meaningful in this theoretical setting.