Academic journal article Federal Reserve Bank of New York Economic Policy Review

Literature Review on the Stability of Funding Models

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Literature Review on the Stability of Funding Models

Article excerpt

* Financial intermediaries perform maturity and liquidity transformation by issuing liquid, short-term liabilities while holding illiquid, longer-term assets.

* This study discusses the intermediaries' role as liquidity provider and the inherent fragility associated with it.

* Yorulmazer reviews the standard framework of the literature to consider factors that make financial intermediaries more or less stable, such as the combination of deposit-taking and loan-making activities and the role of interbank markets for coinsurance against liquidity shocks.

* The study also looks at developments in the financial sector affecting the stability of intermediaries. These include the shift of some activity to less regulated parts of the financial system and the growing importance and size of the repo market.

1. INTRODUCTION

This article provides a review of the economics literature on the stability of banks and other financial intermediaries, with a policy-oriented focus on their funding models. We first discuss the standard framework used in the literature to analyze the fragility of financial institutions that perform maturity and liquidity transformation. Then we consider potential factors that amplify or mitigate such financial fragility. Finally, we review developments in the financial sector that may have affected the stability of funding models.

2. THE STANDARD FRAMEWORK

2.1 What Is Maturity Transformation and Why Does It Cause Illiquidity?

We begin by describing the standard framework used in the literature--which is based on maturity transformation and the risk of a run and loss of significant funding sources--to think about the fragility of financial intermediaries.

One important role played by financial intermediaries is maturity and liquidity transformation, namely, issuing liquid, short-term liabilities while holding illiquid, longer-term assets. This arrangement allows investors to benefit from an intermediary's special skills in making high-return investments while maintaining the ability to shift funds to other uses, if needed. This flexibility is particularly valuable to investors who face significant uncertainty about the timing of their liquidity needs, because a financial intermediary can provide them with insurance against this uncertainty. In this section, we discuss the role of financial intermediaries as liquidity providers and the inherent fragility associated with this role.

In their seminal work, Bryant (1980) and Diamond and Dybvig (1983) provide a framework that illustrates the role of financial intermediaries in providing liquidity insurance. This framework has become the standard platform for studying financial fragility.

In the Diamond-Dybvig model, there are three dates, and depositors are initially uncertain about the date at which they will want to consume. Each depositor will turn out to be either the "early" type, who wants to consume in the interim date, or the "late" type, who wants to consume in the final date. On the initial date, the bank invests the resources collected from the depositors into a long-term asset. This asset yields a return of R > 1 at the final date for each unit invested. However, there is a cost to liquidate the asset early. If the asset is liquidated at an interim date, it yields a return of one per unit invested. Although each depositor is uncertain as to when she will need to consume, the fraction of depositors who will want to consume early is known by the bank. By pooling the funds it collects, the bank can insure depositors against their liquidity-preference shocks. In fact, the bank can achieve an efficient allocation of resources in this environment by offering a contract that promises depositors a consumption level of [c.sub.1] if they withdraw in the interim period, and a consumption level [c.sub.2] if they withdraw in the final period. These values are chosen so that 1 < [c. …

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