Aggregate liquidity and banking sector fragility

As compared to non-banks, banks adopt relatively fragile balance sheet structures characterized by leverage, maturity mismatch, and asset diversification. This paper offers a new potential explanation for this observation, within a model where banks face lower aggregate (funding) liquidity risk than non-banks. This single difference between both provides banks with an incentive to adopt fragile balance sheets, even in the absence of tax distortions, moral hazard, or a special role for banks as liquidity providers. The model implies that banks engage in pro-cyclical risk-taking, are vulnerable to contagion, and will resist regulatory equity and liquidity requirements, while non-banks do not.
 
Keywords: banks, balance sheet fragility, aggregate liquidity, bank equity and liquidity requirements, financial stability.
JEL classifications: E50, G01, G21, G28.

Working paper no. 534.