Liquidity Risk and Competition in Banking

Abstract

Liquidity risk is one of the major risks faced by banks in addition to credit risk, market risk and operating risk. In this paper we construct a stylized model of bank management where the asset and liabilities liquidity structure are a key element in determining the bank's exposure to liquidity risk. The main results of our model are that liquidity risk increases when competition in the credit market increases while increasing competition in the deposit market will decrease the liquidity shortage. Our results are of particular importance as banks face increased liquidity risk due to the recent developments in the financial markets.