Risk diversification and the large-small bank dichotomy in money markets

Abstract

This paper presents a theoretical model based on risk diversification to rationalize the observed dichotomy in money markets by which small banks are net providers of funds while large banks become net purchasers. Unlike the existing literature on this topic, the model incorporates liquidity provision by a central bank. In the model, smaller banks are less diversified and more risky which means producing a lower amount of loans through smaller leverage and borrowing in the wholesale money market with larger risk premiums. Because payment needs for settlement purposes are random and because smaller banks face worse rates in the interbank market, in equilibrium they will obtain from the central bank extra funds for precautionary reasons and offer these excess reserves in the money market. The opposite will be true for large banks.