Financial Intermediation and the Supply of Liquidity

I explore the role of financial intermediaries in supplying liquidity over the business cycle. I consider a model similar to Holmstrom and Tirole (1998), in which firms hold assets to shift current funds to future periods when they may be borrowing constrained. Financial intermediaries insure against loss of credit access by issuing credit lines, but intermediaries are also subject to agency costs whose severity depends on their asset holdings. This creates a linkage between bank balance sheets and the supply of liquidity, in which a fall in bank assets raises the liquidity premium and reduces investment. This provides a novel channel through which a financial crisis may affect the real economy. I analyze optimal policy assuming the government can issue bonds that commit future tax revenue. I find that when there is a positive liquidity premium it will be optimal for the government to issue a positive quantity of bonds. I find that the optimal supply of public liquidity is decreasing in bank assets. This implies that optimal policy in the wake of a financial crisis is to increase the supply of government bonds due to their liquidity properties.