Discussion of “Liquidity, Moral Hazard, and Interbank Market Collapse”

Financial intermediaries, such as banks, perform many roles: they screen risks, evaluate and fund worthy entrepreneurs, pool risks, monitor borrowers, refinance projects, and—when confronted with the default in their loans—they perform a valuable role in loss discovery and assessing whether the bankrupt concern is economically viable or not. All these activities, which constitute the actions of a bank in what concerns the asset side of its balance sheet, need to be funded, and much depends on how the bank structures its liabilities to obtain these funds, whether with time deposits, shortor long-term debt, equity, or other more novel forms of short-term financing such as commercial paper or repo transactions. Independently of the particular liability structure adopted by financial intermediaries, it typically involves some form of maturity transformation. For instance, bank deposits, which are available on demand, are transformed into longer-maturity loans to finance projects. Maturity mismatch is almost inherent in the intermediation business. A liquidity shock for banks occurs whenever at some interim stage additional funds are needed to bridge the maturity mismatch between assets and liabilities. Given the nature of the bank’s balance sheet, there are two potential sources of liquidity problems. First, it may be that projects that were funded at some past date need to be refinanced in some contingency and that failure to provide additional funds may result in some loss or even the wasteful liquidation of those projects. Alternatively, it may be that liabilities are coming due before the proceeds of the investments are realized and that funds need to be produced to meet those liabilities; a bank run is the classic example of the latter. Of course, both things can happen simultaneously: projects on the asset side of the bank’s balance sheet