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Liquidity provision vs. deposit insurance: preventing bank panics without moral hazard

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  • Antoine Martin

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Abstract

In this paper I ask whether a central bank policy of providing liquidity to banks during panics can prevent bank runs without causing moral hazard. This kind of policy has been widely advocated, most notably by Bagehot (1873). I show a particular central bank liquidity provision policy can prevent bank panics without moral hazard problems. I also show that a deposit insurance policy, while preventing runs, can create moral hazard problems. Copyright Springer-Verlag Berlin/Heidelberg 2006

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File URL: http://hdl.handle.net/10.1007/s00199-005-0613-x
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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 28 (2006)
Issue (Month): 1 (05)
Pages: 197-211

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Handle: RePEc:spr:joecth:v:28:y:2006:i:1:p:197-211

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Related research

Keywords: Bank panics; Liquidity provision; Deposit insurance; Moral hazard.;

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References

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  1. Ernst-Ludwig VON THADDEN, 1998. "Liquidity Creation through Banks and Markets : Multiple Insurance and Limited Market Access," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9820, Université de Lausanne, Faculté des HEC, DEEP.
  2. Repullo, R., 1999. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Papers 9913, Centro de Estudios Monetarios Y Financieros-.
  3. Freeman, Scott, 1988. "Banking as the Provision of Liquidity," The Journal of Business, University of Chicago Press, vol. 61(1), pages 45-64, January.
  4. Haubrich, Joseph G. & King, Robert G., 1990. "Banking and insurance," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 361-386, December.
  5. Robert E. Lucas, Jr. & Nancy L. Stokey, 1985. "Money and Interest in a Cash-in-Advance Economy," NBER Working Papers 1618, National Bureau of Economic Research, Inc.
  6. Champ, B. & Smith, B.D., 1991. "Currency Elasticity and Banking Panics: theory and Evidence," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9109, University of Western Ontario, The Centre for the Study of International Economic Relations.
  7. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  8. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
  9. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  10. Yehning Chen, 1999. "Banking Panics: The Role of the First-Come, First-Served Rule and Information Externalities," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 946-968, October.
  11. Stephen D. Williamson, 1995. "Discount Window Lending and Deposit Insurance," Macroeconomics 9504001, EconWPA, revised 18 Apr 1995.
  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  13. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-16.
  14. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
  15. Boyd, John H. & Chang, Chun & Smith, Bruce D., 2002. "Deposit insurance: a reconsideration," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1235-1260, September.
  16. John Boyd & Chun Chang & Bruce Smith, 2004. "Deposit insurance and bank regulation in a monetary economy: a general equilibrium exposition," Economic Theory, Springer, vol. 24(4), pages 741-767, November.
  17. Denise Hazlett, 1997. "Deposit insurance and regulation in a Diamond-Dybvig banking model with a risky technology (*)," Economic Theory, Springer, vol. 9(3), pages 453-470.
  18. Sleet, Christopher & Smith, Bruce D, 2000. "Deposit Insurance and Lender-of-Last-Resort Functions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 518-75, August.
  19. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  20. Russell Cooper & Dean Corbae, 2001. "Financial collapse and active monetary policy: a lesson from the Great Depression," Staff Report 289, Federal Reserve Bank of Minneapolis.
  21. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  22. V.V. Chari, 1989. "Banking without deposit insurance or bank panics: lessons from a model of the U.S. national banking system," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-19.
  23. Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 568-92, June.
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