We aim to study the interaction between bank liquidity and loan monitoring over the business cycle and their distributional impact. The analysis is motivated by various phenomena that in the long run are deepening the markets for bank liquidity. On the regulatory front, also in the wake of the Great Recession, effort has been made to facilitate banks' access to wholesale funding markets. On the banking side, banks' have increased their tendency to accumulate large holdings of sovereign bonds and this has allegedly expanded their collateral and debt capacity in interbank markets, while leaving banks exposed to swings in the price of sovereign bonds. To this end we need to conduct an empirical analysis with bank-level U.S. data to study the existence of pervasive substitution effects between banks' access to liquidity and bank monitoring, especially during recessionary periods. To rationalize these findings, we further need to build a DSGE model with a banking sector that features active loan monitoring and limited access to liquidity, due to borrowing constraints in both the retail and the wholesale funding markets. The model economy also includes a government that issues bonds, used as collateral by banks in the wholesale market. In this framework we can study whether bank monitoring and liquidity tend to comove negatively or positively following recessionary and liquidity shocks. In line of principle, two channels can arise in our model: a "liquidity channel", whereby changes in access to liquidity alter directly banks' incentive to monitor to retain this access; and a "monitoring productivity channel", whereby changes in the value of loans influence the marginal contribution of monitoring in enhancing loan pledgeability.
