Optimal liquidity management and bail-out policy in the banking industry |
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| Institution: | 1. Banking Supervision, Federal Reserve Bank of Dallas, 2200 N Pearl St, Dallas, TX 75201, United States;2. Department of Economics, University of Wisconsin-Milwaukee, Box 413, Bolton Hall 806, Milwaukee, WI 53201, United States;3. Department of Economics, Northeastern University, 360 Huntington Avenue, Boston, MA 02115, United States;1. Tilburg University, Postbus 90153, 5000 LE Tilburg, the Netherlands;2. De Nederlandsche Bank, P.O. Box 98, 1000 AB Amsterdam, the Netherlands;3. CPB Netherlands Bureau for Economic Policy Analysis, Postbus 80510, 2508 GM, The Hague, the Netherlands |
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| Abstract: | We characterize the profit-maximizing reserves of a commercial bank, and the generated probability of a liquidity crisis, as a function of the penalty imposed by the Central Bank, the probability of depositors' liquidity needs, and the return on outside investment opportunities. We demonstrate that banks do not fully internalize the social cost associated with the bail-out policy if the liquidity needs of individuals are correlated, and that competitive interbank markets will induce banks to raise their reserves under reasonable conditions. The marginal benefits from an interbank market decrease as the correlation between the liquidity shocks of banks increases. |
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