MANAGING BANKING FINANCIAL DISTRESS:TRADE-OFFS BETWEEN LIQUIDITY ANDSOLVENCY RISKS

We develop a microeconomic banking framework to analyze how liquiditymanagement decisions influence the availability of liquidity to depositors, the viabilityof the asset transformation process and the solvency of banking firms. In particular,we focus on how the optimal allocation of deposits between reserves and a riskyinvestment portfolio by a profit maximizing bank affects the likelihood of each type ofbank failure in an environment where there is uncertainty on both sides of the balancesheets. Our main aim in this paper, is to examine the risk-management trade-offsbetween those risks arising because of the uncertainty in the behaviour of depositorsand those arising on the asset side of their balance sheet associated with the riskattached to their portfolio investment...