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Money Market Derivatives and the Allocation of Liquidity Risk in the Banking Sector

This paper develops an argument for why banks, in addition to trading in the interbank spot market for liquidity, also use hedging contracts in the interbank business. The argument goes as follows: Due to the fact that large banks are involved in many lines of business and have more depositors than small banks, they receive more precise information about future aggregate developments, e. g. aggregate liquidity shortages. This enables large banks to react in advance on upcoming liquidity shocks and buffer their impact on the entire banking sector.

However, because this information is not available to small banks, large banks can exploit their informational asymmetry to increase their profits at the costs of small banks. Forwards contracts written well in advance, i. e. before large banks receive any signal about the aggregate development, can prevent this. Yet, forward contracts do not implement an efficient mechanism to force large banks to disseminate their information about the aggregate development to small banks. Because it would be cost-efficient if small banks were also able to react in advance to a signal about an upcoming liquidity shortage, such a dissemination of information could be welfare improving.

We show in our approach that lines of credit provided by large banks to small banks can implement a solution to this problem, not only preventing large banks from exploiting their informational advantage at the detriment of small banks, but also urging large banks to provide their information to the whole banking sector. The reason is straightforward. In contrast to forward contracts, lines of credit provide an option to the small banks to receive liquidity at a pre-specified price from the large banks.

If small banks have not been informed about an upcoming liquidity shortage, then they will draw on these credit lines. If the volumes of the lines of credit are sufficiently high, and the interest rate is sufficiently low, this will cause losses to the large bank which overcompensate any additional profit that the bank could make from exploiting its informational advantage. Thus offering such lines of credit against an ex-ante fee is a commitment device for large banks to transmit any signal it receives to the rest of the banking sector. This allows small banks to adjust their liquidity holdings while still enabling large banks to collect a rent for their information dissemination.

Money Market Derivatives and the Allocation of Liquidity Risk in the Banking Sector