Flight to liquidity and the Great Recession

No 1729, Working Paper Series from European Central Bank

Abstract: This paper argues that counter-cyclical liquidity hoarding by financial intermediaries may strongly amplify business cycles. It develops a dynamic stochastic general equilibrium model in which banks operate subject to agency problems and funding liquidity risk in their inter- mediation activity. Importantly, the amount of liquidity reserves held in the financial sector is determined endogenously: Balance sheet constraints force banks to trade off insurance against funding outflows with loan scale. A financial crisis, simulated as an abrupt decline in the collateral value of bank assets, triggers a flight to liquidity, which strongly amplifies the initial shock and induces credit crunch dynamics sharing key features with the Great Recession. The paper thus develops a new balance sheet channel of shock transmission that works through the composition of banks' asset portfolios. JEL Classification: E22, E32, E44

Keywords: bank capital channel; credit crunch; funding liquidity risk; liquidity hoarding; macro-finance (search for similar items in EconPapers)
Date: 2014-09
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-mon
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Related works:
Journal Article: Flight to liquidity and the Great Recession (2015)
Working Paper: Flight-to-Liquidity and the Great Recession (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20141729

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