Liquidity of Bank Assets, Bank Liquidity Holding and Risk Taking

Authors: Yusong Huang (Goethe University)

Title: Liquidity of Bank Assets, Bank Liquidity Holding and Risk Taking

Abstract: How does change in bank assets liquidity influence bank liquidity holding and risk taking? In a model where banks potentially liquidate illiquid assets when facing a liquidity event, I show a bank unambiguously decreases its liquidity holding with the decrease of illiquidity of bank assets. Meanwhile, bank risk taking resembles reversed U-shape with respect to increased liquidity of bank assets. However, these behaviors do not persist when taking into account lack of liquidity in the interbank market. In comparison, a bank now increases its liquidity holding with increased bank assets liquidity, and takes less risk for any given level of asset liquidity. The contrast in behavior sheds light on banking regulation and banking sector dynamics.