Liquidity Management, Fire Sale and Liquidity Crises in Banking: The Role of Leverage

Abstract

This paper proposes a positive theory of the link between banks' capitalisation and their liquidity-risk taking as well as the severity of fire-sale problems and liquidity crises. In the basic framework of an individual bank's decisions, we find that banks' incentives to hold liquidity for precautionary reason are increasing with their capital. In a continuum-of-banks setting in which both precautionary and speculative motives of liquidity holdings are taken into account, we find that while the fire-sale discount is decreasing with the capitalisation of the banking system, the link between the latter and the severity of liquidity crises is not monotonic.

Bank Liquidity Risk and Capital Structure: A Conceptual Review of Theoretical and Empirical Research on Islamic Banking Perspective

“…This can be implemented by encouraging a bank capital change to manage a bank's liquidity risk. The past study conducted by Gomez and Vo (2019) indicated that bank prefer to encounter their liquidity risk cautiously in a situation where their leverage is low. Gomez and Vo (2019) has come up with a model where banks can encounter their liquidity risk standing through the assessment of their liquid asset.…”

“…The past study conducted by Gomez and Vo (2019) indicated that bank prefer to encounter their liquidity risk cautiously in a situation where their leverage is low. Gomez and Vo (2019) has come up with a model where banks can encounter their liquidity risk standing through the assessment of their liquid asset. In this circumstance, banks seem to hold an adequate buffer of liquid asset in order to absorb any losses arise from liquidity risk.…”