Financial Market Liquidity and the Lender of Last Resort

Abstract

Competition and liquidity crisesStrategic behaviours in relation to imperfect competition have been highlighted by some market participants as a possible explanation for tensions in the inter-bank market: some banks may have been reluctant to lend short-term liquidity in order to restore their own market power by weakening their competitors.The link between competition and liquidity crises can be formalised through various approaches: the degree of competition in the banking sector can affect hedging decisions (with respect to liquidity risk), both in terms of the overall level of liquidity provisioning, and in terms of dispersion in hedging strategies.• Banks may compete more aggressively ex ante so as to lock in a larger number of customers whose future liquidity needs constitute future income. Higher competition tends to increase the volume of capital dedicated to illiquid loans. This mechanically reduces the optimal share of liquid assets. Through this negative effect, competition tends to worsen the risk profi le of the pool of liquidity applicants: banks that are short of liquidity make fewer monitoring efforts as they reinvest less of their own liquidity in risky projects. The risk profi le of the pool of liquidity applicants may deteriorate to the point that banks with excess liquidity prefer to hoard it (at the central bank) rather than lend it on the inter-bank market: the market for liquidity then collapses.• There is an alternative mechanism by which competition may amplify adverse selection. Recent literature shows that more competitive industries exhibit higher heterogeneity in hedging. Since hedging decisions are imperfectly observable, competition may therefore contribute to amplify an adverse selection problem on the inter-bank market.These two examples show that competition may, in some circumstances, participate in creating the preconditions for a liquidity crisis. However, competition is known to have powerful benefi ts in terms of reducing the cost of capital. The extent to which the former effect may signifi cantly mitigate the later in welfare terms remains an open question. 9In his article entitled "Liquidity risk management" in this issue of the Financial Stability Review, Goodhart uses the metaphor of "the weary traveler who arrives at the railway station late at night, and, to his delight, sees a taxi there who could take him to his distant destination. He hails the taxi, but the taxi driver replies that he cannot take him, since local bylaws require that there must always be one taxi standing ready at the station".

To Lend or to Borrow on the Interbank Market: What Matters for Commercial Banks in the Visegrad Countries

“…In some cases, banks failed to raise enough cash through asset sales. As a result of liquidity hoarding of some banks, interbank lending become very dif cult and for some banks even impossible (Ewerhart and Valla, 2008). In response to the freezing up of the interbank market, the European Central Bank, the U.S. Federal Reserve and national central banks respond ( ernohorský et al, 2010).…”