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WP – 2024-02-29 – Lukas Voellmy: Decomposing liquidity risk in banking models

Summary:
In various banking models, banks are viewed as arrangements that insure households against uncertain liquidity needs. However, the exact nature of the liquidity risk faced by households – and hence the insurance function of banks – differs across models. This paper attempts to disentangle the different meanings of the term ‘liquidity insurance’ in the literature and to clarify what kind of insurance banks provide in which models. The paper also shows under which conditions banking is equivalent to eliminating uncertainty about liquidity needs or letting households trade with each other in an asset market. Special attention is given to the comparison of banking models in the tradition of Diamond and Dybvig (1983) with those based on monetary (notably New Monetarist)

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In various banking models, banks are viewed as arrangements that insure households against uncertain liquidity needs. However, the exact nature of the liquidity risk faced by households – and hence the insurance function of banks – differs across models. This paper attempts to disentangle the different meanings of the term ‘liquidity insurance’ in the literature and to clarify what kind of insurance banks provide in which models. The paper also shows under which conditions banking is equivalent to eliminating uncertainty about liquidity needs or letting households trade with each other in an asset market. Special attention is given to the comparison of banking models in the tradition of Diamond and Dybvig (1983) with those based on monetary (notably New Monetarist) frameworks.

Swiss National Bank
The Swiss National Bank conducts the country’s monetary policy as an independent central bank. It is obliged by the Constitution and by statute to act in accordance with the interests of the country as a whole. Its primary goal is to ensure price stability, while taking due account of economic developments. In so doing, it creates an appropriate environment for economic growth.

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