Aggregate Liquidity and Banking Sector Fragility

Abstract

As compared to non-banks, banks adopt relatively fragile balance sheet structures characterized by leverage, maturity mismatch, and asset diversification. This paper offers a new potential explanation for this observation, within a model where banks face lower aggregate (funding) liquidity risk than non-banks. This single difference between both provides banks with an incentive to adopt fragile balance sheets, even in the absence of tax distortions, moral hazard, or a special role for banks as liquidity providers. The model implies that banks engage in pro-cyclical risk-taking, are vulnerable to contagion, and will resist regulatory equity and liquidity requirements, while non-banks do not.