#08-40
The Dark Side of Bank Wholesale Funding
Rocco Huang and Lev Ratnovski, 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 liquidations. We show that the "dark side" of wholesale funding dominates 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 modern banking system
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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