Abstract

We develop a two-period model where banks invest in liquid reserves and loans, and are subject to aggregate liquidity shocks. When banks face a shortage of liquidity, they can sell loans on the interbank market. Two types of equilibria emerge. In the no default equilibrium, banks keep enough reserves and remain solvent. In the mixed equilibrium, some banks default with positive probability. The former equilibrium exists when credit market competition is intense, while the latter emerges when banks exercise market power. Thus, competition is beneficial to financial stability. The structure of liquidity shocks affects the severity and the occurrence of crises, as well as the amount of credit available in the economy.