A Theory of Bank Illiquidity and Default with Hidden Trades*

Abstract

I develop a theory of financial intermediation to explore how the availability of trading opportunities affects the link between the liquidity of financial institutions and their default decisions. In it, banks hedge against liquidity shocks either in the interbank market or by using a costly bankruptcy procedure, and depositors trade in the asset market without being observed. In this environment, the competitive pressure from the asset markets makes intermediaries choose an illiquid asset portfolio. I prove three results. First, illiquid banks default in equilibrium only when there is systemic risk and an unpredicted crisis hits the economy. Second, in contrast to the previous literature, the allocation at default is not socially optimal. Third, the constrained efficient allocation can be decentralized with the introduction of countercyclical liquidity requirements.

Market participation in a two-sector Diamond-Dybvig economy

“…Interestingly, this conclusion complements a previous analysis that finds that, in environments with banks and markets, an unexpected shock to the fundamentals of one sector may not lead to bankruptcy or to financial contagion to the whole economy (Panetti, 2014). However, more work is needed to reconcile these findings with the observation that the reaction of the banking system to anticipated shocks to fundamentals is instead inefficient (Panetti, 2013). These considerations are left for future research.…”