Discussion Paper Details

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Title: Speculative and Precautionary Demand for Liquidity in Competitive Banking Markets

Author(s): Diemo Dietrich and Thomas Gehrig

Publication Date: February 2021

Keyword(s): competitive bank business models, expenditure needs, Investment opportunities, liquidity insurance and Penalty rates

Programme Area(s): Financial Economics and Industrial Organization

Abstract: We demonstrate that the co-existence of different motives for liquidity preferences profoundly affects the efficiency of financial intermediation. Liquidity preferences arise because consumers wish to take precautions against sudden and unforeseen expenditure needs, and because investors want to speculate on future investment opportunities. Without further frictions, the co-existence of these motives enables banks to gain efficiencies from combining liquidity insurance and credit intermediation. With standard financial frictions, banks cannot reap such economies of scope. Indeed, the co-existence of a precautionary and a speculative motive can cause efficiency losses which would not occur if there were only a single motive. Specifically, if the arrival of profitable future investment opportunities is sufficiently likely, such co-existence implies inefficient separation, pooling, or even non-existence of pure strategy equilibria. This suggests that policy implications derived solely from a single motive for liquidity demand can be futile.

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Bibliographic Reference

Dietrich, D and Gehrig, T. 2021. 'Speculative and Precautionary Demand for Liquidity in Competitive Banking Markets'. London, Centre for Economic Policy Research.