Banks and liquidity: a theoretical view

A model analysing the interbank market and liquidity crises indicates that banks need to be more liquid.

The model, constructed by economists at Banque de France, relies on three key assumptions:

· that the provision of liquidity is unverifiable;

· that banks face moral hazard when confronted with liquidity shocks; and

· that liquidity shocks are private information.

Under these assumptions, the equilibrium risk-adjusted return on the provision of liquidity rises with the aggregate

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