The Dark Side of Bank Wholesale Funding

IMF Working Papers, July 1, 2010

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Banks increasingly use short-term wholesale funds to supplement traditional retail deposits.
Existing literature mainly emphasizes the "bright side" of wholesale funding: sophisticated financiers can monitor banks, disciplining bad but refinancing good ones.
This paper models a "dark side" of wholesale funding: in an environment with a costless but noisy public signal on bank project quality, short-term wholesale financiers have lower incentives to conduct costly monitoring and instead may withdraw based on negative public signals, triggering inefficient liquidations.

Short-term wholesale financiers’ incentives to monitor are reduced when a public signal—costless but noisy—on bank project quality exists.
Withdrawals based on negative public signals can trigger inefficient liquidations, even when refinancing would be socially valuable.
The model contrasts the monitoring/refinancing role of sophisticated financiers (the "bright side") with strategic withdrawal behavior (the "dark side").

Distortions of incentives are smaller when:
- public signals are less relevant, and
- project liquidation costs are higher.
An example context where distortions are smaller: banks holding mostly relationship-based small business loans (higher liquidation costs).

Reliance on short-term wholesale funding can introduce systemic fragility when public signals are noisy and financiers under-monitor.
Mitigating the "dark side" may involve:
- reducing the relative importance of noisy public signals in financiers’ decision-making, and
- recognizing that higher liquidation costs (e.g., relationship lending) can dampen harmful run-like behavior.

Source: The Dark Side of Bank Wholesale Funding, IMF Working Paper by Lev Ratnovski and Rocco Huang, July 1, 2010.