Liquidity, Moral Hazard and Inter-Bank Market Collapse

This paper proposes a framework to analyze the functioning of the inter-bank liquidity market and the occurrence of liquidity crises. The model relies on three key assumptions: (i) liquidity provisioning is not verifiable -it cannot be contracted upon-, (ii) banks face moral hazard when confronted with liquidity shocks-unobservable effort can help overcome the shock-, (iii) liquidity shocks are private information - they cannot be diversified away-. Under these assumptions, the equilibrium risk-adjusted return on liquidity provisioning increases with the aggregate equilibrium volume of ex ante liquidity provision. As a consequence, banks may provision too little liquidity compared with the social optimum. Within this framework we derive two main results. First inter-bank market collapse is an equilibrium. Second such an equilibrium is more likely when (i) the individual probability of the liquidity shock is lower, (ii) ex ante competition between banks on illiquid long term assets is larger.