Working Paper: CEPR ID: DP9311
Authors: Elena Carletti; Agnese Leonello
Abstract: We develop a model where banks invest in reserves and loans, and face aggregate liquidity shocks. Banks with liquidity shortage sell loans on the interbank market. Two equilibria emerge. In the no default equilibrium, all banks hold enough reserves and remain solvent. In the mixed equilibrium, some banks default with positive probability. The former exists when credit market competition is intense. The latter emerges when banks exercise market power. Thus, competition is beneficial to financial stability. The structure of liquidity shocks affects the severity and the occurrence of crises, as well as the amount of credit available in the economy.
Keywords: default; interbank market; price volatility
JEL Codes: G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased credit market competition (G19) | Enhanced financial stability (G28) |
| Increased credit market competition (G19) | Banks hold sufficient reserves (G21) |
| Banks hold sufficient reserves (G21) | Avoiding defaults (D10) |
| Increased competition (L13) | Banks behave more prudently (G21) |
| Degree of competition (L13) | Profitability of loans relative to holding reserves (G21) |
| Profitability of loans relative to holding reserves (G21) | Banks' incentives to manage liquidity risk (G21) |
| Lower competition (L13) | Risky banks may default due to inadequate reserves (G21) |
| Severity of crises (H12) | Amount of available credit (E51) |
| Structure of liquidity shocks (E44) | Severity of crises (H12) |