Bank Bailouts and Aggregate Liquidity Diamond, Douglas W.; Rajan, Raghuram G.
The American economic review,
05/2002, Letnik:
92, Številka:
2
Journal Article
Recenzirano
The critical point made by Diamond and Rajan is that, while it is well understood that aggregate liquidity conditions can affect bank solvency, it is less well understood but equally important to ...note that bank solvency can affect aggregate liquidity. Depending on the characteristics of the banks that are in danger of failing, their failure can either subtract from the aggregate pool of liquidity or add to it. As is shown, it may be possible that the natural sequence of bailouts leads to an escalating set of bailouts, which culminates only when the government has no more resources to infuse. More generally, bailout decisions that increase the excess demand for liquidity can cause further insolvencies, and indeed, a meltdown of the entire system, where contagion is spread via the common pool of liquidity.
This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face ...privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.
In legal systems with expensive or ineffective contract enforcement, it is difficult to induce lenders to enforce debt contracts. If lenders do not enforce, borrowers will have incentives to ...misbehave. Lenders have incentives to enforce given bad news when debt is short-term and subject to runs caused by externalities across lenders. Lenders will not undo these externalities by negotiation. The required number of lenders increases with enforcement costs. A very high enforcement cost can exceed the ex ante incentive benefit of enforcement. Removing lender's right to immediately enforce their debt with a "bail-in" can improve the ex ante incentives of borrowers. PUBLICATION ABSTRACT
Many claims have been made about the potential benefits and the potential costs of adopting a system of universal banking in the United States. We evaluate these claims using a model where there is a ...moral hazard problem between banks and "borrowers," a moral hazard problem between banks and a deposit insurer, and a costly state verification problem. Under conditions we describe, allowing banks to take equity positions in firms strengthens their ability to extract surplus, and exacerbates problems of moral hazard. The incentives of universal banks to take equity positions will often be strongest when these problems are most severe.
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