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.

I would like to acknowledge the support of the Barcelona GSE Research Network as well as the financial support of the Spanish Ministry of Science and Competition through grant ECO2012-38460 and of the Generalitat de Catalunya through Grant 2014SGR-1446. I am also grateful for financial support from the ADEMU pro ject, “A Dynamic Economic and Monetary Union”, funded by the European Union’s Horizon 2020 Program under grant agreement No 649396.

Trabajo presentado en el 41 Simposio de la Asociación Española de Economía, celebrado en Bilbao, del 14 al 17 de diciembre de 2016

Peer reviewed