Liquidity, Moral Hazard, and Interbank Market Collapse

This paper proposes a framework to analyze the functioning of the interbank liquidity market and the occurrence of liquidity crises. The model relies on three key assumptions: (i) ex ante investment in liquid assets 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, and (iii) liquidity shocks are private information-they cannot be diversified away. Under these assumptions, the aggregate volume of capital invested in liquid assets is shown to exert a positive externality on individual decisions to hoard liquid assets. Due to this property, the collapse of the interbank market for liquidity is an equilibrium. Moreover, such an equilibrium is more likely when the individual probability of the liquidity shock is lower. Banks may therefore provision too few liquid assets compared with the social optimum.