Survey_CI_2008

Abstract

The basic idea of our model is fairly straightforward: Financial intermediaries can choose to invest in more or less (real) liquid assets. We model illiquidity in the following way: some fraction of projects turns out to be realised late. The aggregate share of late projects is endogenous, it depends on the incentives of financial intermediaries to invest in risky, illiquid projects. This endogeneity allows us to capture the feedback from liquidity provision to risk taking incentives of financial intermediaries. We show that the anticipation of unconditional central bank liquidity provision will encourage excessive risk taking (moral hazard). It turns out that in the absence of liquidity requirements, there will be overinvestment in risky activities, creating excessive systemic risk. In our model, we concentrate on pure illiquidity risk: There will never be insolvency unless triggered by illiquidity (by a bank run). Illiquid projects promise a higher, yet possibly retarded return. Relying on sufficient liquidity provided by the market (or by the central bank), financial intermediaries are inclined to invest more heavily in high yielding, but illiquid long term projects. This paper extends a model developed in Cao & Illing (2007). In the economy, there are three types of agents: investors, banks (run by bank managers) and entrepreneurs. All agents are risk neutral. The economy extends over 3 periods. We assume that there is a continuum of investors each initially (at t = 0) endowed with one unit of resources. The resource can be either stored (with a gross return equal to 1) or invested in the form of bank equity or bank deposits. Using these funds, banks as financial intermediaries can fund projects of entrepreneurs.