The Dark Side of Bank Wholesale Funding
Rocco Huang
Federal Reserve Bank of Philadelphia
Lev Ratnovski
International Monetary Fund
November 2008
Abstract
Commercial banks increasingly use short-term wholesale funds to supplement traditional retail deposits.
Existing literature mainly points to the “bright side” of wholesale funding: sophisticated financiers can monitor banks, disciplining bad ones but refinancing solvent ones.
This paper models a “dark side” of wholesale funding.
In an environment with a costless but imperfect signal on bank project quality (e.g., credit ratings, performance of peers), short-term wholesale financiers have lower incentives to conduct costly information acquisition, and instead may withdraw based on negative but noisy public signals, triggering inefficient cient liquidations.
We show that the “dark side” of wholesale funding dominates the “bright side” when bank assets are more arm’s length and tradable (leading to more relevant public signals and lower liquidation costs): precisely the attributes of a banking sector with securitizations and risk transfers.
The results shed light on the recent financial turmoil, explaining why some wholesale financiers did not provide market discipline ex-ante and exacerbated liquidity risks ex-post.
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