LIQUIDITY PROVISION, BANKING, AND THE ALLOCATION OF INTEREST-RATE RISK

The paper studies the efficient allocation of technology-induced interest rate risk and the implications of such risk for efficient liquidity provision. Complete immunization against interest rate risk is shown to be undesirable as it precludes the exploitation of favourable reinvestment opportunities. Under the assumptions of Diamond-Dybvig (1983), interest-induced valuation risks of long-term assets should be born by early withdrawers, reinvestment opportunity risks of short-term assets by late withdrawers. Efficient liquidity provision thus entails no shifting of interest rate risk. In the absence of additional moral hazard, second-best allocations can be implemented through unregulated competition among banks.