Research On Inter - Bank Market Under The Impact Of Heterogeneous Liquidity

Why have too-big-to-fail policies persisted for decades? This paper provides an ex-planation by studying the causal relationship between idiosyncratic liquidity shocks and the freezing of transfers in the interbank markets. For a more realistic concern, I formalize my observation of Asian bank systems—large banks provide a mechanism for the alloca-tion of resources, and in China bank rout favors big lenders over small—into my model. Moreover, banks have incentives to originate risks of different credit qualities depending on their ability to refinance ex post. That is an ex ante moral hazard mechanism. When idiosyncratic liquidity shocks occur, small banks in distress choose to borrow from intact ones and large banks, which give birth to the ex post moral hazard mechanism. In this paper, banks’ reliance on self-insurance versus outside liquidity is determined under the combination of the such two moral hazards. Collapse of markets can occur when large banks are not "large" enough. Therefore, calls for sliming down mega banks so that they could fail safely, might deserve reconsideration.