A Model of Bank Liquidity

53 Pages Posted: 9 Aug 2010

See all articles by Jianbo Tian

Jianbo Tian

SUNY at Albany - Department of Economics

Date Written: August 8, 2010

Abstract

This paper introduces LLSS ratio as a new bank liquidity measurement. The new measurement reveals banks' ability to roll over long term loans on short term savings. Such ability is determined by both banks' liquid/illiquid asset allocation and the interbank market environment. I use ABCP and MBS to represent the interbank operations, which provide banks external funds to absorb the liquidity shocks. A two period model shows that a mature MBS and ABCP market can effciently raise banks' LLSS ratio without compromising the banking industry's safety margin. The conclusion is quite different from the wide belief that MBS is the channel for banks to transfer risk to investors. MBS and ABCP serve as Arrow-Debreu securities for banks to share and eliminate liquidity shocks, and improves banks' profit margin indirectly. LLSS ratio was raised by 20%, from 35% in 1990 to 55% in 2005, which helped the banking industry to earned $50B net interest more each year and to reduce the bank failures from over 150 cases annually in the early 1990s to less than 5 cases in the early 2000s. More important, the model predicts the interbank market's limit. The estimated LLSS ratio safety boundary is around 55%. After 2006, LLSS ration reached a dangerous high level of 65%. The market was overloaded and at the edge of collapse. The banking industry lost it buffer to absorb any negative shocks, and the moderate losses of $500B in mortgage triggered a global crisis.

Keywords: liquidity, mortgage, subprime crisis, bank run

JEL Classification: D12, G12, G21

Suggested Citation

Tian, Jianbo, A Model of Bank Liquidity (August 8, 2010). Available at SSRN: https://ssrn.com/abstract=1655268 or http://dx.doi.org/10.2139/ssrn.1655268

Jianbo Tian (Contact Author)

SUNY at Albany - Department of Economics ( email )

BA125A, 1400 Washington Ave,
Albany, NY 12222
United States

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