Strategic Liquidity Mismatch and Financial Sector Stability

This paper examines the impact of banks’ collective liquidity mismatch policies on the stability of the financial sector. Using a novel identification strategy exploiting the presence of partially overlapping peer groups, I show that the liquidity created by individual banks is driven by the liquidity transformation activity of their peers. These correlated liquidity mismatch decisions are asymmetric and concentrated on the asset-side component of liquidity creation. Importantly, this strategic behavior increases both the default risk of individual institutions and overall systemic risk. From a macroprudential perspective, the results highlight the importance of explicitly regulating systemic liquidity risk.