Wednesday, May 4, 2016 | 2:00pm-3:30pm | Room 335, HSBC Business School Building

Abstract

We model the interplay between trade in the interbank market and creditor runs on financial
institutions. We show that the feedback between them can amplify a small shock into interbank
market freezing with liquidity evaporating. Credit crunches of the interbank market drive
up the interbank rate. For an individual institution, a higher interbank rate meaning a
higher funding cost results in more severe coordination problems among creditors in debt
rollover decisions. Creditors thus behave more conservatively and run more often. Facing an
increased chance of creditor runs, institutions demand more and supply less liquidity, tightening
the interbank market. Our model demonstrates that banking crises arise from a shrinking of
the pool of aggregate liquidity.