Amsterdam PhD Finance Seminars

Mario Milone (Universite Paris Dauphine, France)
Wednesday, 10 June 2015

I study the risk taking trade off between liquidity management and risk management for a bank investing in long-term illiquid assets and short-term risky securities. I focus on the choice of correlation between long-term and short-term assets in a model with liquidity risk. Because times of liquidity distress lead to endogeneous firesale losses, the bank has incentives for risk management and diversification. However, limited liability leads the bank to increase its profits in good states, hence correlating securities with long term assets. This trade off results in an endogeneous choice of risk on the aggregate assets holdings. I analyse how liquidity risk characteristics influence the bank risk taking behavior and I discuss implications for changes in capital requirements.