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Pocket Banks and Out-of-Pocket Losses: Links between Corruption and Contagion

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Author Info
Raphael H. Solomon
Abstract

The author describes a model with a corrupt banking system, in which bankers knowingly lend at market interest rates to back projects riskier than the market rate indicates. Faced with early withdrawals, bankers turn to an interbank market, which may be available in an unfettered way, available but subject to screening, or unavailable. The presence of corruption increases the probability of contagious bank failure significantly. This fact holds in a perfect information environment, as well as in some environments with imperfect information. The model suggests that financial stability can be imperilled by corrupt lending.

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File URL: http://www.bankofcanada.ca/en/res/wp/2005/wp05-23.pdf
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Paper provided by Bank of Canada in its series Working Papers with number 05-23.

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Length: 37 pages
Date of creation: 2005
Date of revision:
Handle: RePEc:bca:bocawp:05-23

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Related research
Keywords: Financial institutions; Financial stability;

Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
G19 - Financial Economics - - General Financial Markets - - - Other
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages

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  1. Haizhou Huang & Chenggang Xu, 2000. "Financial Institutions, Financial Contagion, and Financial Crises," IMF Working Papers 00/92, International Monetary Fund.
    Other versions:
  2. Xavier Freixas & Bruno M. Parigi & Jean-Charles Rochet, 2003. "The Lender of Last Resort: A 21st Century Approach," Economics Working Papers 708, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
    Other versions:
  3. 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. [Downloadable!]
  4. Fleming, Alex & Lily Chu & Bakker, Marie-Renee, 1996. "The Baltics - Banking crises observed," Policy Research Working Paper Series 1647, The World Bank. [Downloadable!]
  5. Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 111-28, February.
  6. Harsanyi, John C, 1995. "Games with Incomplete Information," American Economic Review, American Economic Association, vol. 85(3), pages 291-303, June.
    Other versions:
  7. Kevin Dowd, 2000. "Bank Capital Adequacy versus Deposit Insurance," Journal of Financial Services Research, Springer, vol. 17(1), pages 7-15, February. [Downloadable!] (restricted)
  8. Miguel Cantillo and Julian Wright., 2000. "How Do Firms Choose Their Lenders? An Empirical Investigation," Research Program in Finance Working Papers RPF-256-Rev, University of California at Berkeley. [Downloadable!]
    Other versions:
  9. Allen N. Berger & Nathan H. Miller & Mitchell A. Petersen & Raghuran G. Rajan & Jeremy C. Stein, 2002. "Does function follow organizational form? evidence from the lending practices of large and small banks," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 383-400.
    Other versions:
  10. Rafael La Porta & Florencio López-de-Silanes & Guillermo Zamarripa, 2003. "Related Lending," The Quarterly Journal of Economics, MIT Press, vol. 118(1), pages 231-268, February. [Downloadable!] (restricted)
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  11. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April. [Downloadable!] (restricted)
    Other versions:
  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. [Downloadable!] (restricted)
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  13. Petersen, Mitchell A & Rajan, Raghuram G, 1994. " The Benefits of Lending Relationships: Evidence from Small Business Data," Journal of Finance, American Finance Association, vol. 49(1), pages 3-37, March. [Downloadable!] (restricted)
  14. Nikolay Nenovsky & Evgeni Peev & Todor Yalamov, 2003. "Banks-Firms Nexus under the Currency Board: Empirical Evidence from Bulgaria," William Davidson Institute Working Papers Series 555, William Davidson Institute at the University of Michigan Stephen M. Ross Business School. [Downloadable!]
  15. Laeven, Luc, 2001. "Insider Lending and Bank Ownership: The Case of Russia," Journal of Comparative Economics, Elsevier, vol. 29(2), pages 207-229, June. [Downloadable!] (restricted)
  16. Charumilind, Chutatong & Kali, Raja & Wiwattanakantang, Yupana, 2003. "Connected Lending: Thailand before the Financial Crisis," CEI Working Paper Series 2003-19, Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University. [Downloadable!]
    Other versions:
  17. Huther, Jeff & Shah, Anwar, 2000. "Anti-corruption policies and programs : a framework for evaluation," Policy Research Working Paper Series 2501, The World Bank. [Downloadable!]
  18. Steven Drucker & Manju Puri, 2004. "Tying knots: lending to win equity underwriting business," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 428-435. [Downloadable!]
  19. Sangkyun Park, 1994. "Explanations for the increased riskiness of banks in the 1980s," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 3-24. [Downloadable!]
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