SSRN Id3350684
SSRN Id3350684
SSRN Id3350684
Abstract
Banks may be reluctant to remove bad loans from their portfolios during liquidity
shortfalls, giving rise to a moral hazard problem. In this paper, we analyze how
liquidity shortages affect the ability of the interbank market to provide liquidity in
a moral hazard setting. We distinguish two types of liquidity shocks that arise due
to a deposit flight (a contraction in the deposit supply) or to a cash-flow shock (an
increase in the non-performing loans). We show that the source of a liquidity shortfall
is the main determinant of the decision of banks to stop lending in the interbank
market, rather than the extra amount of funds that banks need to cover. An increase
in the non-performing loans has more adverse effects on balance sheets than a deposit
flight. We also demonstrate that competition has a dual effect on financial stability.
Interbank competition enhances financial stability by reducing the liquidity provision
cost, whereas credit market competition worsens financial stability by inducing banks
to take riskier profiles.
2 The model
We consider a three-period model, t = {0, 1, 2}, with two banks (A and B) that are monop-
olists in their short-term deposit markets. Each market contains a unit mass continuum of
identical agents. For simplicity, we assume that there is no discounting between the periods.
In this economy, banks A and B can invest in a long-term portfolio of loans that takes I
units of deposits at date 0 and produces Cf < I and R > I units of consumption at dates
1 and 2, respectively. Nevertheless, the probability of loan maturity differs between banks,
being such probability lower for Bank A.
2.1 Depositors
There are two independent deposit markets, labelled as A and B. Each market contains a
continuum of identical depositors with endowments of I and ω in periods 0 and 1, respec-
tively. Depositors consume only in periods 1 and 2, and their savings are their only resource
for consumption in period 2.
We assume that the bank is the only mean available for depositors to allocate consumption
from one period to another. They lend funds to the bank as short-term deposits to save,
which are held from t to t + 1. Since deposits are protected by deposit insurance, depositors
receives gross interest rates of r0 and r1 in periods 1 and 2, respectively.
We assume that individual preferences are specified by the following constant relative
risk-aversion utility function:
cθ1 cθ2
U (c1 , c2 ) = + , (1)
θ θ
where ct denotes the consumption at period t, and the risk-aversion parameter θ determines
2.2 Banks
We assume that both banks carry out the same long-term investment that is funded only
through retail deposits at period 0. The investment yields an income of Cf at period 1 and
either R > I or no income at period 2. The probability of producing an income of R differs
across banks A and B. Bank A gets R with probability PL , while the probability of getting
R is PH for Bank B, where PH > PL .
In the interim stage, Bank A suffers a liquidity shock but also has the chance of removing
bad loans from its portfolio. Then, Bank A can keep its original portfolio, with a probability
of repayment of PL , or it can restructure its portfolio to improve the quality of the loans, at
a cost of τ . In the latter case, the probability of success increases to PH , where we assume
that PH = 1, without loss of generality.
Bank A also faces a liquidity shortage that stems from one of two mutually exclusive
equiprobable shocks: a decrease in the deposit supply or a reduction in the cash flow caused
by an increase in its NPLs. Both shocks decrease the present value of the bank, but they
have different effects. An increase in the NPLs reduces the cash flow of the bank by α > 0,
and the bank receives Cf − α instead of Cf .
Under a deposit shock, Bank A suffers a contraction of its deposits and, consequently,
an increase in its financing cost. Then, both shocks do not affect neither the payment R
nor the probability of the success of the project {PL , PH }. These liquidity shocks, however,
change the incentives of Bank A to remove bad loans, making this investment riskier.
cθ1j cθ2j
max + ,
ctj ,stj θ θ
c1j + s1j = ωj + I,
s.t.
c = s r ,
2j 1j 1j
where ctj and stj denote the consumption and saving allocations, respectively, at period
t and under shock j. We derive the consumption and saving functions of period 1 from
the maximization problem above. We denote the consumption and saving functions by
C1j (r1j ; ωj ) and S1j (r1j ; ωj ), respectively. In addition, the inverse-deposit supply at t = 1
after the occurrence of a shock of type j = {C, D} is given by:
θ−1
(ωj + I − s) θ
Γ1j (s; ωj ) = .
s
The inverse-deposit supply Γ1j (s; ωj ) determines the interest rate that Bank A must pay
to gather an amount s of funds from the deposit market. Since the endowment of depositors
in Market B is not affected by any type of shocks, the inverse-deposit supply in that market
is given by
θ−1
(ω + I − s) θ
Γ1 (s; ω) = .
s
Deposit shocks arise because of a sudden drop of size ρ in the income of depositors.
Nevertheless, the liabilities of Bank A that should be renewed are LD ≡ L. As a result,
deposit shocks increase the cost of obtaining new financing from the deposit market so that
Γ1D (s, ωD ) > Γ1C (s, ωC ). Thus, the cost of renewing its obligation in autarky (without
interbank liquidity provision) is:
We assume now that Bank A may borrow from the interbank market short-term funds
to substitute retail deposits. Then, after the occurrence of a shock of type j ∈ {C, D}, Bank
A should choose the optimal allocation of deposit and interbank funds x that minimize its
funding cost. Bank A chooses the level of x that solves the following problem:
where sA
j (x; Cf ) ≡ Lj − x is the amount of deposits that Bank A needs to gather from
the deposit market after obtaining x units from the interbank market. Thus, the first term
of CjA (x) is the cost of obtaining sA
j (x; Cf ) deposits, while the second one is the cost of
borrowing an amount of x funds from the interbank market. By solving the minimization
problem above, we obtain the demand of Bank A for interbank funds:
10
where XjA (RI ) = 0 if the interbank interest rate is higher than the marginal cost of renewing
the obligations of Bank A in the deposit market. Accordingly, we define the inverse demand
for interbank funds in state j as follows:
A
∂Γ1j sA
j (x); ωj ∂sj (x) A
RIj (x) ≡ Γ1j sA
j (x); ωj − s (x). (2)
∂s ∂x j
where S1D (r̂1 ; ωD ) is the volume of deposits supplied by consumers at the rate r̂1 in state D.
Accordingly, the liquidity needs of Bank A are the difference between the obligations that
should be renewed and the amount of deposits obtained at the interest rate r̂1 . Then, if we
define the cash-flow shock equal to α(ρ), the liquidity needs for Bank A are the same in both
states.
In state C, Bank A should renew an amount of obligations given by LC = L + α(ρ).
Bank A can only obtain S1C (r̂1 ; ωC ) = L at the deposit rate r̂1 . Therefore, Bank A suffers
a liquidity shortfall of size α(ρ) regardless the type of shock, for any value of ρ.
11
where PH R are the loan returns when they have a high probability of success (PH ), τ is the
cost of restructuring its portfolio, and Γ1j (Lj ; ωj )Lj + τ is the total cost of the bank under
autarky. If Bank A does not restructure its loan portfolio, then the net present value of its
investment will be negative regardless of the occurrence of shocks. This assumption can be
written as follows:
where Γ1 (L; ω) and L are the inverse-deposit supply and the liabilities of both banks that
should be renewed in period 1 if Bank A is not affected by any shocks, respectively. Therefore,
if Bank A takes liquidity from the interbank market keeping its original portfolio, lenders
will lose money in expectation. Accordingly, interbank trading is zero.
We assume that Bank B can identify the type of shock that occurs, but it is unable
to observe the behavior of Bank A. Therefore, Bank B lends to Bank A an amount of x
in state j only if Bank A has incentives to restructure its portfolio such that the following
incentive-compatibility constraint holds:
PH R − Γ1j (sA A A A
j (x); ωj )sj (x) − RI x − τ ≥ PL R − Γ1j (sj (x); ωj )sj (x) − RI x . (4)
In addition, we assume that Bank B only provides funds in the interbank market after it
has renewed all the obligations incurred by its investment, L = I − Cf . Then, the net cost
of providing an amount x of interbank loans is:
12
where Γ1 (sB (x); ω)sB (x) is the cost of obtaining an amount of sB (x) deposits from Market
B, Γ1 (sB (0); ω)sB (0) is the cost of the investment of Bank B, and sB (x) ≡ L + x is the
amount of deposits that Bank B has to raise if it supplies x units of interbank funds.
As in Carletti and Leonello (2019), the cost of interbank funds does not depend on the
state j. Although the depositors of Market B are unaffected by any type of shock, liquidity
shocks affect the compatibility constraint of (4) and the availability of funds in the interbank
market. Accordingly, the volume of funds, supplied at the interbank rate RI , is obtained
from the following maximization problem:
where X̃ B (RI ) = xB is the supply of interbank funds in the absence of a moral hazard
problem, and xB is implicitly defined as
13
∗ ∗
(1) XjA (RIj ) = X̃ B (RIj ) = x∗j ;
(2) PH R − Γ1j (sA ∗ A ∗ ∗ ∗ A ∗ A ∗ ∗ ∗
j (xj ); ωj )sj (xj ) − RIj xj − τ ≥ PL R − Γ1j (sj (xj ); ωj )sj (xj ) − RIj xj .
∗
An AIE is possible as long as the demand of Bank A for interbank funds, XjA (RIj ), does
∗
not exceed its debt capacity. Consequently, an AIE arises only if XjA (RIj ) satisfies condition
(2) of Definition 1 for j = {C, D}. In this equilibrium, banks and depositors maximize their
profits and utility, respectively, and all markets clear. Hence, funds are allocated efficiently,
and the impaired bank can partially reduce the financial cost produced by a liquidity shortage
of size α(ρ).
The model may also produce a “Market Freeze Equilibrium” (MFE), where there is no
RI at which interbank lending occurs. Trading is not possible under this equilibrium. If this
equilibrium occurs, both banks are unable to gather funding from external sources so that
an inefficient allocation arises.
Definition 2 Market Freeze Equilibrium: A MFE exists in this economy if, given a
∗
liquidity shortfall of size α, there is no interbank interest rate RIj , for j = {C, D}, such that
both conditions (1) and (2) of Definition 1 are simultaneously satisfied.
In our analysis, a MFE occurs when the borrowing debt capacity is impaired because of
the asymmetric information across banks A and B. Under a MFE, the impaired bank funds
all its obligations through its own deposit market, regardless of whether it is affected by a
deposit flight or a cash-flow shock. Finally, we define a third possible equilibrium by “Mixed
Equilibrium” as follows.
14
6.1 Autarky
We first analyze the impact that each shock has on the financial costs of Bank A, when it
funds all its liquidity needs exclusively in the deposits market.
Proposition 4 For any ρ ∈ [0, ρmax ], liquidity shortfalls of size α(ρ) have a greater cost
for the impaired bank if they come from the asset side of the balance sheet. In particular,
a cash-flow shock always incurs higher costs than those generated by a deposit-flight shock:
Γ1C (LC ; ωC )LC ≥ Γ1D (LD ; ωD )LD .
Proposition 4 implies that cash-flow and deposit shocks have different effects on the
financing costs of Bank A, although they generate the same liquidity needs. This result arises
because the mechanism behind each shock is different. Under a deposit flight, depositors
need to be compensated by a higher interest rate to keep their money in the bank for another
period. Then, Bank A has to pay a higher interest rate to the depositors, decreasing their
overall profitability. The increase in the interest rate caused by this shock worsens the equity
of the bank as deposits will be renewed at a higher cost. In this case, the total cost under
autarky is the following:
where the first term on the right-hand side of the equation above is the total cost of renewing
the liabilities of both banks when there is no shock, and the second term is the decrease in
equity due to the increase in interest paid, which is defined as:
15
where the term in parentheses is the increase in the interest rate generated by a deposit
shock.
Suppose now that the bank suffers an increase in its NPLs. Then, the cash-flow level
of the bank is reduced, generating a decrease of α in the cash flow. This drop in the cash
flow should be compensated by an increase in the liabilities of the bank from L to LC . By
attempting to cover this funding shortage, Bank A has to raise the interest rate on deposits
to attract more deposits. The total cost can be decomposed into the sum of the costs in
the absence of shocks, the increment in the interest paid (∆EQC ), and the increase in the
liabilities due to the shock (α(ρ)):
where the total amount of interest paid under a cash-flow shock is given by:
Proposition 4 states that cash-flow shocks are costlier than deposit shocks: Γ1C (LC ; ωC )LC ≥
Γ1D (LD ; ωD )LD . Therefore,
As a result, banks that undergo an increase in their NPLs have weaker balance sheets
than those affected by a deposit-flight shock.
16
Lemma 1 For all values of ρ, it is possible to find an interest rate R̃Ij such that XjA (R̃Ij ) =
X̃ B (R̃Ij ) = x̃j . Then, condition (1) of Definition 1 always holds.
Lemma 1 shows that if the moral hazard problem does not arise, then interbank trading
will be always possible. Accordingly, Lemma 1 states that the moral hazard problem is the
unique reason that explains an interbank market freeze in our model. We now determine
under which conditions the interbank market is able to provide liquidity to the impaired
bank.
Proposition 5 There is an upper bound ρC such that, for all ρ ∈ [0, ρC ], both conditions
(1) and (2) of Definition 1 simultaneously hold; thus, the banking system reaches an Active
Interbank Market Equilibrium.
Proposition 6 There exists a value of ρD such that, for all ρ ∈ (ρC , ρD ], the banking system
reaches a Mixed Equilibrium. In this equilibrium, the interbank market only provides funds
17
Proposition 1 establishes that cash-flow shocks are more adverse than deposit shocks
when Bank A has only one source of financing. Proposition 6 entails that a cash-flow shock
is still costlier than a deposit shock if Bank A has access to the interbank market because
CIB (x) is not affected by shocks.
In addition, an increase in the interest rate produced by a deposit flight can be partially
offset by replacing deposits with a cheaper source of funding such as interbank loans. Nev-
ertheless, the increment in liabilities of the banks due to a cash-flow shock, α(ρ), cannot be
offset by taking more debt from the interbank market. Thus, a cash-flow shock harms more
the debt capacity of Bank A than a deposit shock does. As a result, for all ρ in (ρC , ρD ], the
following inequalities simultaneously hold:
where R̃IC denotes the interbank market-clearing rate in the absence of a moral hazard
problem. These inequalities above show that Bank A has an incentive to reduce its exposure
to bad loans only under a deposit shock, while it keeps its original portfolio if a cash-flow
shock occurs. Hence, Bank B supplies no funds under a cash-flow shock because of the
different impact of this shock on the balance sheet of Bank A.
Finally, the second statement of Proposition 6 asserts that a MFE is reached when
liquidity shortfalls are sufficiently large (if ρ > ρD ). This result follows since the incentive-
compatibility constraint of Definition 1 is not satisfied regardless of the shock type.
Fig. 2 displays the interbank market dynamics for different sizes of liquidity shocks. The
curves XjA and CCj are the demand for interbank funds and the incentive-compatibility
constraint for states of nature j = {C, D}, respectively, and X̃ B is the supply of funds in
the absence of a moral hazard problem.
If a shock of type j occurs, then the incentive-compatibility constraint (4) is satisfied on
and below the curve CCj . The points A and B represent the equilibrium in the interbank
market under a cash-flow and a deposit shock, respectively, if the problem of moral hazard
does not arise. Accordingly, the points A and B stand for an equilibrium only if the inter-
section between X̃ B and XjA lies on or below the curve CCj . All of the mentioned curves
are functions of the volume of interbank funds x.
18
(c) If ρ > ρD , the interbank market collapses (a MFE occurs) (d) Type of equilibrium as a function of liquidity shortages
Fig. 2.(d) delineates the types of equilibrium as a function of liquidity shortages in three
regions. Each one of them contains the values of ρ such that the model leads to an AIE, a
ME, or a MFE.
Overall, our model highlights the importance of moral hazard for interbank trading. The
19
20
where
A
A
∂Γ 1j s j (x j ); ω j ∂sj (xj ) A
RIj (xj ) = Γ1j sA
j (x j ); ωj − s (xj )
∂s ∂xij j
ωj + I − θsA j (xj ) A
1
− θ−1
= Γ 1j s j (x j ); ω j ,
sAj (xj )
PN
with xj = i=1 xij . The first-order condition for an interior profit-maximizing level of liq-
uidity is
∂πijB (xij , x−ij ) ∂RIj (xj ) dCi (xij )
≡ xij + RIj (xj ) − = 0. (5)
∂xij ∂xij dxij
Given N banks and a liquidity shock with type j = {C, D}, a pure-strategy Nash equi-
librium is a set of interbank loans (x∗1j (N ), . . . , x∗N j (N )), in which each one of the banks
maximizes its profits and
PN
where x*j (N ) = i=1 x∗ij (N ). For simplicity, we consider only a symmetric equilibrium
x∗ij (N ), for all i, in which all banks follows the same strategy in the equilibrium. Let
(x∗1j , . . . , x∗N j ) be the competitive equilibrium, where limN →∞ x∗ij (N ) = x∗ij , limN →∞ x∗j (N ) =
x∗j , RIj (x∗ ) = dCi (x∗ij )/dxij , and CCj (x∗j ; RIj (x∗j )) > 0. The following proposition summa-
rizes how the interaction between banks under Cournot competition affects the liquidity
provision through the interbank market, in a moral hazard setting.
Proposition 7
(i) Liquidity shortfalls have a greater cost for the impaired bank if they come from the
asset side of the balance sheet, regardless of the degree of competition in the interbank
market:
CCD (x; RID (x)) > CCC (x; RIC (x)) , for all x.
21
(iii) If banks have convex costs, d2 Ci (xij )/dx2ij > 0, and the competitive equilibrium holds,
CCj (xj ∗ ; RIj (x∗j )) > 0, then the interbank equilibrium (x∗1j (N ), . . . , x∗N j (N )) can be
ensured only if the number of banks satisfies N > Nj such that RIj (xj ∗ (N )) > RIj (x∗j ),
after a shock of size ρj for j = {C, D}.
(iv) A higher number of banks is necessary to restore the interbank market under a cash-flow
shock than under a deposit shock: NC > ND . Hence, the liquidity provision through the
interbank market is more sensitive to the level of competition when cash-flow shocks
occur.
Part (i) of Proposition 7 follows because the cost of interbank funds is independent of
the type of shock. Therefore, cash-flow shocks are costlier than deposit shocks regardless of
the level of competition in the interbank market.
The existence of a competitive equilibrium, CCj x∗j ; RIj (x∗j ) > 0, is a necessary condi-
tion for reaching an interbank equilibrium because the liquidity cost is the lowest possible
in a competitive market. Then, the more competitive the interbank market, the higher the
amount of liquidity that Bank A can gather to mitigate liquidity shocks, which reduces its
incentives to misbehave. Hence, if Bank A has incentives to misbehave in a competitive
market, then it will also misbehave in a less competitive market in which liquidity is costlier.
Part (ii) of Proposition 7 entails that banks always offer an amount of liquidity to restore
the interbank trading with a higher interbank rate, when they have constant marginal costs
and the competitive equilibrium holds. The presence of constant marginal is crucial to
restore the interbank trading, regardless of the number of banks in the market. A single
bank acting as liquidity provider is able to provide the competitive amount of liquidity with
non-negative profits. Hence, a lower level of competition leads to a higher interbank rate,
without collapsing the liquidity provision of the interbank market.
Part (iii) Proposition 7 indicates that a low level of bank competition may collapse the
interbank liquidity provision, when banks have convex costs, d2 Ci (xij )/dx2ij > 0, and the
competitive equilibrium holds. This result follows because a small number of banks do not
find it optimal to supply a huge amount of liquidity to induce Bank A to behave, since
the convexity of the cost function leads to negative profits. As a result, the interbank
market breaks down. The aggregate liquidity supply increases with the number of banks,
22
Proposition 8 An increase in credit market competition reduces the ability of the interbank
market to act as a liquidity provider because:
(i) Credit market competition increases the cost of interbank funds so that ∂ X̃ B (RI ; Cf )/∂Cf >
23
(ii) Credit market competition exacerbates the moral hazard problem by eroding the margin
of profits of Bank A:
∂CCj (x; RI ; Cf ) ∂CCj (x; RI ; Cf )
> 0 and > 0.
∂Cf ∂R
Fig. 3 illustrates the impact of credit market competition on the interbank market. Fig.
3.(a) displays an interbank market equilibrium if a shock of type j occurs and the level of
credit market competition is low. The intersection between XjA and X̃ B occurs at the point
A below the curve CCj . Eq. (4) is satisfied, and Bank B provides an amount of liquidity x∗j
to Bank A in the interbank market.
Fig. 3.(b) shows that the same liquidity shock has different effects on financial stability as
the level of credit market competition increases. An increase in credit market competition
undermines the cash flow of banks A and B, making them more dependent on external
funding. This leads to an increase in the demand for deposits and, hence, to an increment
in the deposits rates.
Consequently, a higher deposits rate in Market A raises the demand for interbank funds
0
from XjA to XjA since Bank A is willing to substitute retail deposits for interbank loans, to
mitigate the impact of greater competition on deposit rates.
Credit market competition also raises the deposit rate in Market B. This implies an
0
upward shift of the supply in the absence of the moral hazard problem from X̃ B to X̃ B .
Hence, the intersection of these curves moves from A to A0 , implying a greater cost for Bank
A. Both the higher cost and the reduced cash flow of Bank A exacerbate the moral hazard
0
problem, and the compatibility constraint curve shifts downwards from CCj to CCj . As a
0 0 0
consequence, the intersection between XjA and X B lies above the curve CCj so that the
interbank market fails, harming financial stability.
8 Conclusions
This paper develops a model to explain the relationship between the type of liquidity shock
and the ability of the interbank market to provide liquidity. We employ a moral hazard
model with limited liability to study the mechanism by which liquidity shocks operate. A
key element in our model is that banks are monopolists in their own deposit markets, but
they may trade funds in the interbank market when a shock occurs.
24
25
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Appendix
Technical Assumptions
We first present a set of technical assumptions under which our model is well specified. We
define an upper-bound of PL as follows.
Γ1 (L; ω)
P̄L ≡ .
R
The following assumption is necessary to ensure that the net present value of the invest-
ment of Bank A is negative when it does not restructure its portfolio.
Assumption 1
PL < P̄L .
We also need to impose a condition to ensure that if a bank behaves prudently, then its
investment always has a positive net present value. We define a lower bound for R as follows:
R ≡ Γ1C (L − α(ρ̄); ωC ) + τ.
Assumption 2
R ≥ R.
33
I +ω
ρ̄¯ ≡ Cf ,
I − Cf
and
where ρ̄(θ) is implicitly defined in the Proof of Proposition 1. The threshold ρ̄¯ avoids negative
cash flows in period 1. That is, if ρ ≤ ρ̄¯, then Cf ≥ α(ρ). Besides, the threshold ρ̄(θ)
guarantees that an increase in the NPLs is costlier than a deposit shock for the bank.
Proposition 4 does not hold when ρ > ρ̄(θ) because depositors become reluctant to renew
their deposits. Since there is a negative relationship between θ and the saving elasticity to
the deposit rate, then ρmax is equal to ρ̄(θ) only for small values of θ.
Assumption 3
ρ ≤ ρmax .
ω ≡ L + ρ̄¯.
The following assumption is a sufficient condition to ensure that CjA (x) is a convex
function and π B (x) is a concave function of x. Thus, the second-order conditions for the
optimization problems of Bank A and Bank B are satisfied.
Assumption 4
ω ≥ ω.
34
Assumption 5
(ii) All liquidity suppliers have the same cost function Ci (xij );
(iii) The cost function of liquidity suppliers Ci (xij ) belongs to the family of functions Ω;
Proofs
Proof of Proposition 1:
To prove that cash-flow shocks incur a higher cost than deposit shocks in autarky, we
proceed as follows. First, we derive a result that holds for several utility functions. This
result states that for small values of ρ, a cash-flow shock always generates a higher financial
cost than a deposit shock. Next, we find an upper-bound ρ̄(θ) such that if the preferences
of depositors are represented by the utility function of Eq. (1), then cash-flow shocks are
costlier than deposit shocks on the interval [0, ρ̄(θ)].
a) If the consumption and saving functions of depositors in the absence of shocks are
differentiable and satisfy
∂S1 (r̂1 ; ω) ∂C1 (r̂1 ; ω)
≥ > 0,
∂ω ∂ω
then it is a sufficient condition to ensure that a cash-flow shock always generates a higher
financial cost than a deposit shock for small values of ρ.
We know that Γ1 (s; ω) denotes the inverse-deposit supply if no shocks occurs in period
1. Hence, the bank’s cost of obtaining an amount of saving s = L from the deposit market
is:
Γ1 (L; ω)L.
Let us see how a deposit shock and a cash-flow shock affect such cost. A deposit shock
arises because of a sudden drop of ρ in the income of depositors. Hence, ωD ≡ ω − ρ is the
35
Conversely, a cash-flow shock does not affect the deposit supply, but it increases the
deposit needs of Bank A. According to Eq. (3), for any value of ρ, Bank A suffers a cash-
flow shock of size
Bank A must obtain the following amount of savings from the deposit market to keep
operating at t = 1:
LC (ρ) ≡ L + α(ρ).
Since we are analyzing the effect of small shocks, we define a linear approximation of LC (ρ)
at the point ρ = 0 as follows:
dα(0)
L̃C (ρ) ≡ L + ρ, (A.1)
dρ
where dα(0)/dρ = ∂S1D (r̂1 ; ω)/∂ω. Then, the financial cost of Bank A after suffering a small
cash-flow shock is given by:
To determine which shock is more adverse to the bank, we define the function
as the difference between the financial costs produced by each type of shock. We show
now that this function is strictly decreasing in the neighborhood of ρ = 0, which implies
that cash-flow shocks are costlier than deposit shocks when ρ is small. To this purpose, we
differentiate γ(ρ) with respect to ρ, and we evaluate it at ρ = 0 as follows:
36
" #
∂Γ1 (L; ω) ∂Γ1 (L; ω) ∂ L̃C (0) ∂ L̃C (0)
L + + Γ1C (L̃C (0); ωC ) > 0.
∂ω ∂s ∂ρ ∂ρ
∂Γ1 (s; ω) 1
= ∂S1 (r1 ;ω)
,
∂s
∂r1
and we can rewrite the slope of S1 (r1 ; ω) with respect to the interest rate as
" #
∂Γ1 (L; ω) 1 ∂ L̃C (0) ∂ L̃C (0)
L − ∂C1 (r̂1 ;ω)
+ Γ1C (L̃C (0); ωC ) > 0.
∂ω ∂ρ ∂ρ
∂r1
Moreover, from Eq. (A.1), we have that ∂ L̃C (ρ)/∂ρ = ∂S1 (r̂1 ; ω)/∂ω. Hence,
" #
∂Γ1 (L; ω) 1 ∂S1 (r̂1 ; ω) ∂S1 (r̂1 ; ω)
L − ∂C1 (r̂1 ,ω)
+ Γ1C (L̃C (0); ωC ) > 0. (A.2)
∂ω ∂ω ∂ω
∂r1
37
" ∂C #
1 (L;ω) ∂S1 (r̂1 ;ω)
∂ω ∂ω ∂S1 (r̂1 ; ω)
L ∂C1 (r̂1 ,ω)
− ∂C1 (r̂1 ;ω)
+ Γ1C (L̃C (0); ωC ) > 0.
∂ω
∂r1 ∂r1
b) If the utility function of consumers is given by Eq. (1), then γ(ρ) ≤ 0 for any ρ ∈
[0, ρ̄(θ)]. Hence, a cash-flow shock generates a greater financial cost than a deposit shock.
θ−1 θ−1
ω − ρ + Cf θ ω + Cf − α(ρ) θ
γ(ρ; θ) = (I − Cf ) − (I − Cf + α(ρ)),
I − Cf I − Cf + α(ρ)
| {z } | {z }
Γ1D (LD ; ωD )LD Γ1C (LC ; ωC )LC
where α(ρ) = [ρ(I − Cf )]/(I + ω). We also know by item (a) that γ(ρ) is negative around
ρ = 0. We can solve the equation γ(ρ̄; θ) = 0 for θ to implicitly define the threshold ρ̄(θ):
38
dρ̄(θ) 1
= dH(ρ̄) > 0,
dθ − dρ̄
∂α(ρ̄)
dθ(ρ̄; Cf ) µ1 1 1− ∂Cf
=− 2 − < 0, (A.4)
d Cf µ2 ω − ρ̄ + Cf ω + Cf − α(ρ̄)
| {z }
+
and
We apply this result in the Proofs of Propositions 2, 3, and 4 since it implies that the
threshold ρ̄ increases with Cf , for a given θ.
Proof of Lemma 1:
Lemma 1 states that if the moral hazard problem does not arise, then there is a unique
interbank rate R̃Ij such that XjA (R̃Ij ) = X̃ B (R̃Ij ) = x̃j and, hence, this market clears.
To prove this result, let λj (x) for j = {C, D} be the difference between dπ B (x)/dx and
dCjA (x)/dx as follows:
39
∂Γ1D (sA B B
D (0); ωD ) ∂Γ1 (s (0); ω)
λD (0) = Γ1D (sA
D (0); ωD ) − ΓB B
(s (0); ω) + − L > 0,
| {z 1 } | ∂s {z ∂s }
+
+
where sA B
D (0) = LD , s (0) = L, and LD = L. The first term of the right-hand side of the
equation above is positive because ωD < ωC so that Γ1D (L; ωD ) > Γ1 (L; ω). In addition, the
term inside brackets is given by:
" − θ1 − θ1 #
1−θ ω − ρ + Cf ω + Cf
(I + ω − ρ) − (I + ω) > 0,
θ(I − Cf )2 I − Cf I − Cf
| {z } | {z }
+ +
which is positive for any ρ > 0. Hence, it follows that λD (0) > 0. If Bank A meets all its
liabilities from the interbank market x = LD , then
where sA B
D (LD ) = 0. Moreover, s (LD ) = 2L because Bank B needs to renew its deposits by an
amount L, and it lends L in the interbank market. Since Γ1j (0; ωj ) = 0, ∂Γ1j (0; ωj )/∂s = 0,
and ∂ΓB B
1 (s (Lj ); ω)/∂s > 0 for j = {C, D}, we have that λD (LD ) < 0.
Under a cash-flow shock, if x = 0, then
40
where sA
C (0) = LC . The first term of the right-hand side of the equation above is positive
because LC > L implies Γ1C (LC ; ωC ) > Γ1 (L; ω). Moreover, the term inside brackets is given
by:
" − 1 − θ1 #
(1 − θ)(I + ω) ω + Cf − α(ρ) θ I − Cf ω + Cf
− > 0,
θ(I − Cf ) I − Cf + α(ρ) I − Cf + α(ρ) I − Cf
| {z }| {z }
+ +
which is positive for any ρ > 0. As a result, λC (0) > 0. If x = LC , we have that
where sA B
C (LC ) = 0 and s (LC ) = L + LC since Bank B needs to gather L + LC deposits
from the market (L units to renew its own liabilities and LC units to lend in the interbank
market).
Since λj (0) > 0 and λj (Lj ) < 0, there is a unique x̃j ∈ (0, Lj ) such that λj (x̃j ) = 0.
Finally, the clearing interbank rate R̃Ij is given by:
∂Γ1 sB (x̃j ); ω B
R̃Ij = s (x̃j ) + Γ1 (sB (x̃j ); ωC ) , (A.5)
∂s
which is unique because R̃Ij is an increasing function of x.
We prove Propositions 2 and 3 in two steps. First, we show that a cash-flow shock is
still costlier than a deposit shock for the bank, under the presence of an interbank market.
41
Step I: Under the presence of an interbank market, cash-flow shocks are still costlier than
deposit shocks.
As defined before, CjA (x; RI ) is the total cost of a shock of type j = {C, D} when the
impaired bank replaces retail deposits with an amount x of interbank loans. Then, let Ψ(x)
A
be the difference between CD (x; RI ) and CCA (x; RI ) as follows:
Ψ(x; RI ) ≡ Γ1D sA
A A
A
D (x); ωD sD (x) + RI x − Γ1C sC (x); ωC sC (x) + RI x ,
| {z } | {z }
A (x; R )
CD A (x; R )
CC
I I
C̃f
z }| { ! θ−1 C̃f
θ
ω − ρ + (Cf + x) z }| {
Ψ(x; RI ) = (I − (Cf + x))
I − (Cf + x)
| {z }
C̃f
| {z }
Γ1D (sA A
D (x); ωD )sD (x)
C̃f
z }| { ! θ−1 C̃f
θ
ω − α(ρ) + (Cf + x) z }| {
− (I + α(ρ) − (Cf + x)) . (A.6)
I + α(ρ) − (Cf + x)
| {z }
C̃f
| {z }
Γ1C (sA A
C (x); ωC )sC (x)
Now, let us show that Ψ(x; RI ) < 0 for any x > 0. This is an instrumental result to
prove that CCA (x∗C ; RIC
∗ A ∗
) > CD ∗
(xD ; RID ). By defining C̃f ≡ Cf + x > Cf , then Ψ(x; RI )
approximates the function γ(ρ) when the cash flow is equal to C̃f instead of Cf . Recall that
γ(ρ) is the difference between the financial costs produced by each type of shock in autarky.
However, Ψ(x; RI ) differs from γ(ρ) because α(ρ) = ρ(I − Cf )/(I + ω) cannot be rewritten
as a function of C̃f . By Proposition 1, it follows that in autarky (x = 0)
42
θ−1
ω − ρ + Cf + x θ
0 > γ(ρ; C̃f ) > (I − (Cf + x))
I − (Cf + x)
| {z }
Γ1D (sA A
D (x); ωD )sD (x)
θ−1
ω + (Cf − α(ρ) + x) θ
− (I − (Cf − α(ρ) + x)) = Ψ(x; RI ). (A.7)
I − (Cf − α(ρ) + x)
| {z }
Γ1C (sA A
C (x); ωC )sC (x)
The inequality (A.7) follows because CCA (x; RI ) increases with α(ρ). Thus, CCA (x; RI ) >
A
CD (x; RI ). Finally, let us show that CCA (x∗C ; RIC
∗ A ∗
) > CD ∗
(xD ; RID ). We know that
Ψ(x∗C ; RIC
∗ A ∗
) = CD ∗
(xC ; RIC ) − CCA (x∗C ; RIC
∗
) < 0.
∗
Under a deposit shock, the financial cost of the bank is minimized at x∗D = XD ∗
(RID ).
A ∗ ∗ A ∗ ∗
Hence, CD (xD ; RID ) < CD (xC ; RIC ). Therefore,
A ∗ ∗
CD (xD ; RID ) < CCA (x∗C ; RIC
∗
),
which implies that cash-flow shocks are still costlier than deposit shocks when the impaired
bank obtains funding from the interbank market.
As discussed before, Bank A can access interbank funds only if the conditions (1) and
(2) of Definition 1 are simultaneously satisfied. From Lemma 1, condition (1) always holds.
Hence, the compatibility constraint (condition (2)) determines whether Bank A can get
external financing from the interbank market under any type of shock.
Let ρj be the highest value of ρ such that the compatibility constraint of Definition 1
holds if a shock of type j = {D, C} occurs. The upper bounds for ρ are implicitly defined
from the incentive-compatibility constraint of Eq. (4) as follows:
τ ∗ ∗ ∗ ∗
= R − Γ1C (sA A
C (xC ); ωC )sC (xC ) − RIC xC ,
∆P | {z }
A (x∗ ; R∗ )
CC C IC
43
τ ∗ ∗ ∗ ∗
= R − Γ1D (sA A
D (xD ); ωD )sD (xD ) − RID xD .
∆P | {z }
A (x∗ ; R∗ )
CD D ID
By Step I, cash-flow shocks are costlier than deposit shocks so that ρC < ρD . Hence,
the banking system reaches an AIE if ρ ∈ [0, ρC ] because the compatibility constraint holds
for both type of shocks. Nevertheless, if ρ > ρC , then the compatibility constraint is only
satisfied under a deposit shock, implying that a ME arises when ρ ∈ (ρC , ρD ]. Finally, the
interbank market freezes under both type of shocks if ρ > ρD .
Proof of Proposition 4:
Before proceeding to the Proof of Proposition 4, we derive two auxiliary results. Facts
1-2 below ensure the existence and uniqueness of the Cournot equilibrium in the absence
of a moral hazard problem. Part (ii) of Fact 2 also implies that the incentive-compatibility
constraint CCj (xj , RIj (xj )) is increasing in N , for a liquidity shock ρj , because the interbank
rate is decreasing with the number of banks.
Fact 1:
Proof of Fact 1:
44
and
∂H sA 4
j (xj ); ω; θ 1−θ 1 θ
A
= 2 3 + A
− A
> 0,
∂sj (xj ) 1 + ω − s (x ) 1 + ω − θs (x )
sA (x )
j j
j j j j
| {z }
+
1 θ3
H(y, ω, θ) 6 H(1, ω, θ) = − (1 − θ) − ,
ω2 (1 − θ + ω)
where H(1, ω, θ) is strictly decreasing in ω. Hence,
Fact 2
PN
(i) Let (x̂∗1j (N ), . . . , x̂∗N j (N )) and x̂j = i=1 x̂∗ij (N ) be the Cournot equilibrium and the
total amount of liquidity supplied in the market in the absence of moral hazard, respec-
tively. Then, for any ρj , the equilibrium (x̂∗1j (N ), . . . , x̂∗N j (N )) exists and is unique;
45
(iii) The incentive-compatibility constraint CCj x∗j (N ), RIj (x∗j (N )) is increasing in the
number of banks N .
Proof of Fact 2:
are sufficient conditions for the existence and uniqueness of the Cournot equilibrium in
the absence of a moral hazard problem. Besides, Vives (1999) shows that Assumption 5
and Fact 1 are sufficient conditions for part (ii) of Fact 2. Finally, part (ii) of Fact 2 and
∂CCj (xj , RIj (xj ))/∂RIj < 0 entail that CCj (x∗j (N ), RIj (x∗j (N ))) is increasing in the number
of banks N .
The Proof of Proposition 7 follows from Facts 1-2. Part (i) of Proposition 7 is straightfor-
ward. Proposition 4 states that cash-flow shocks are costlier than deposit shocks in autarky.
The cost of interbank funds Ci (xij ) is independent of shocks; then, the marginal cost of pro-
viding liquidity in the interbank market is the same under both types of shocks. Therefore,
cash-flow shocks are costlier than deposit shocks regardless of the level of competition in the
interbank market, and part (i) of Proposition 7 holds.
To prove parts (ii)-(iii), we need to distinguish two cases determined by the compatibility
constraint CCj (xj ; RIj (xj )) > 0. If x̂j (N ) satisfies CCj (x̂j (N ); RIj (x̂j (N ))) > 0, then part
(i) of Fact 2 implies that the interbank equilibrium is given by x∗j (N ) = x̂∗j (N ), for all i,
because there is no moral hazard problem in the market.
Nevertheless, if CCj (xˆj (N ); RIj (x̂j (N ))) < 0, then x̂∗j (N ) cannot be an equilibrium be-
cause Bank A has incentives to misbehave. In this case, the existence of a competitive
equilibrium CCj (x̂∗j ; RIj (x̂∗j )) > 0 is a necessary condition to ensure an interbank equilib-
rium with N banks. If CCj (x̂∗j ; RIj (x̂∗j )) > 0, then there exists a value x0j ∈ (x̂∗j (N ), x̂∗j ]
46
The existence of a competitive equilibrium implies that πijB (x0i , x0−i ) > πijB (x̂∗i , x̂∗−i ) = 0.
Thus, no bank has incentives to deviate from x0ij . As a result, part (ii) of Proposition
7 holds; if banks have constant marginal costs and the competitive equilibrium satisfies
CCj (x̂∗j ; RIj (x̂∗j )) > 0, then x∗ij (N ) = x0ij , for all i, is a Cournot equilibrium in the interbank
market with x̂∗j > x0j > x∗j (N ).
To prove part (iii), suppose now that banks have convex costs, d2 Ci (xij )/dx2ij > 0, and
the competitive equilibrium holds,
CCj x̂∗j ; RIj (x̂∗j ) > 0 > CCj x̂∗j (N ); RIj (x̂∗j (N )) .
If the competitive equilibrium holds, parts (ii)-(iii) of Fact 2 imply that there is a number
of banks N j such that x̂∗j (N j ) = x0j . As a result, for all N > N j , we have that
Then, part (iii) of Proposition 7 follows, and the equilibrium in the interbank market is
x∗ij (N ) = x̂∗ij (N ) for all i and for all N > N j .
Finally, part(i) of Proposition 4 together with part (ii) of Fact 1 imply that x0C > x0D .
Under a cash-flow shock, a higher amount of liquidity is necessary to avoid that Bank A
misbehaves than under a deposit shock, which entails that N C > N D . Then, part (iv)
47
Proof of Proposition 5:
Before proceeding to the proof of the Proposition 5, we derive the following auxiliary
result.
Fact 3:
(a) The objective functions of Bank A and Bank B are convex and concave, respectively.
Then, the second-order conditions for an interior solution of xA B
j and x are satisfied.
∂Γ1j (sA A
j (x);Cf ) ∂sj (x)
(c) ∂s ∂Cf
< 0.
Proof of Fact 3:
− θ1
ωj
∂ 2
CjA (x) (1 − θ) ωj2 sA (x) −1
j
= 2 > 0,
∂x2 θ2 sj (x) ωj − sA
A
j (x)
48
Hence, the second-order condition of the maximization problem of Bank B is also satisfied.
∂ 2 π B (x) ∂ 2 Γ1 (sB (x); ω) ∂sB (x) B ∂Γ1 (sB (x), ω) ∂sB (x)
=− s (x) − 2
∂x∂Cf ∂s2 ∂Cf ∂s ∂Cf
∂ 2 Γ1 (sB (x); ω) B ∂Γ1 (sB (x); ω)
= s (x) + 2 > 0,
∂s2 ∂s
because ∂sB (x)/∂Cf = −1.
− 1
∂Γ1j (sA A
j (x); Cf ) ∂sj (x)
θ − 1 ωj + Cf + x θ ωj + I
= < 0.
∂s ∂Cf θ sA
j (x) (sA
j (x))
2
49
∂ 2 π B (xB )
∂ X̃ B (RI ; Cf ) ∂x∂C
= − ∂ 2 πB (xfB ) > 0.
∂Cf 2
∂x
Hence, credit market competition increases the cost of interbank funds, and it intensifies
the dependence of the impaired bank on external funding.
∂CCj (x; RI ; Cf )
= 1,
∂R
and
∂Γ (sA (x), ω ) ∂sA (x) ∂sA
∂CCj (x; RI ; Cf ) j (x)
1j j j j
= − +Γ1j (sA
j (x), ωj ) > 0,
∂Cf ∂s ∂Cf ∂Cf
| {z }
−
as ∂sA
j (x)/∂Cf = −1. The sign of the derivative above implies that credit market
competition leads to a downward shift in the curve CCj (x). Therefore, credit market
competition exacerbates the moral hazard problem in the interbank market.
50
51