The Dark Side of Liquidity Creation: Leverage and Systemic Risk

This paper exposes a fundamental tension between the micro-prudential objective of subjecting banks to greater discipline through debt markets and the macro-prudential objective of containing systemic risk. We show that banks are illiquid due to the inability of bankers to credibly pre-commit to asset choices. Bank debt can reduce this illiquidity by disciplining bankers with the threat of premature liquidations. However, the liquidation of a bank's assets leads creditors of other banks to update their priors on common shocks affecting asset values, giving rise to contagion and liquidations throughout the system. Thus, liquidity creation induced by the disciplining role of bank debt has the benefit of generating more information about common asset-value shocks, but it comes at the cost of greater systemic risk, risk that is not fully internalized by banks in choosing privately optimal levels of leverage. We then consider implications of a lender of last resort (LOLR) that intervenes to bail out banks when faced with the prospect of a contagion. While LOLR interventions can diminish the incidence of contagion and thereby reduce systemic risk, they also carry the misfortune of eliminating efficient liquidations. . In particular, by reducing creditor incentives to intervene in banks, the LOLR can preclude the discovery of “early warnings” of a banking crisis and risk the emergence of a delayed but more severe crisis. JEL: