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A Theory of Bank Illiquidity and Default with Hidden Trades

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  • Ettore Panetti

Abstract

How does the availability of alternative investment opportunities for banks’ depositors affect the reaction of the banking system to aggregate liquidity shocks? And what are the implications, if any, for banking regulation? To answer these questions, I study a Diamond–Dybvig environment, where banks hedge against aggregate liquidity risk in the interbank market or default, and depositors borrow and lend in a hidden-bond market. In this framework, banks offer an endogenously incomplete contract, and default in equilibrium only when facing systemic liquidity risk. In this case, the allocation at default is inefficient, and countercyclical liquidity requirements are welfare-improving.

Suggested Citation

  • Ettore Panetti, 2017. "A Theory of Bank Illiquidity and Default with Hidden Trades," Review of Finance, European Finance Association, vol. 21(3), pages 1123-1157.
    • Handle: RePEc:oup:revfin:v:21:y:2017:i:3:p:1123-1157.
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    Cited by:

    1. Ettore Panetti, 2016. "Bank Runs: Theories and Policy Applications," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.

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    More about this item

    Keywords

    Financial intermediation; Default; Liquidity; Hidden trades; Regulation;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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