To Sell or to Borrow? A Theory of Bank Liquidity Management

This paper studies banks’decision whether to borrow from the interbank market or to sell assets in order to cover liquidity shortage in presence of credit risk. The following trade-off arises. On the one hand, tradable assets decrease the cost of liquidity management. On the other hand, uncertainty about credit risk of tradable assets might spread from the secondary market to the interbank market, lead to liquidity shortages and socially ineffi cient bank failures. The paper shows that liquidity injections and liquidity requirements are effective in eliminating liquidity shortages and the asset purchases are not. The paper explains how collapse of markets for securitized assets contributed to the distress of the interbank markets in August 2007. The paper argues also why the interbank markets during the 2007-2009 crisis did not freeze despite uncertainty about banks’quality.