DP19602 Scope and Limits of Bank Liquidity Provision
In standard banking models a preference for liquidity arises because investors want to take pre-cautions against sudden expenditure needs. It has long been taken for granted that banks’ maturity transformation is because they insure against such expenditure needs, exposing them to crises and justifying bank regulation. We show that if a preference for liquidity arises additionally for another important reason, their co-existence substantially alters equilibrium outcomes. Specifically, we introduce investors who want to preserve flexibility in case better investment opportunities arrive later. We show that 1) maturity transformation does not emerge without further frictions, 2) equilibria in models that consider only a single reason for liquidity preferences are not necessarily robust, 3) an equilibrium in pure strategies in the depositing game may not exist at all.
