Faculty of Economics and Business Administration Publications Database

Liquidity Coinsurance and Bank Capital

Castiglionesi, Fabio
Feriozzi, Fabio
Loranth, Gyongyi
Volume: 46
Number: 2-3
Pages: 409 - 443
Month: March-April
ISSN-Print: 0022-2879
Link External Source: Online Version
Year: 2014
Keywords: G21; Bank capital; Interbank markets; Liquidity coinsurance

Banks can deal with their liquidity risk by holding liquid assets (self-insurance), by participating in interbank markets (coinsurance), or by using flexible financing instruments, such as bank capital (risk sharing). We use a simple model to show that undiversifiable liquidity risk, that is, the liquidity risk that banks are unable to coinsure on interbank markets, represents an important risk factor affecting their capital structures. Banks facing higher undiversifiable liquidity risk hold more capital. We posit that, empirically, banks that are more exposed to undiversifiable liquidity risk are less active on interbank markets. Therefore, we test for the existence of a negative relationship between bank capital and interbank market activity and find support in a large sample of U.S. commercial banks.