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Banking Crises, Implicit Government Guarantees, and Optional Insurance

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  • Pablo Druck
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    Abstract

    After major banking crisis, investors and academics alike are left wondering how it could have been avoided. Crises can take an enormous toll on society. Mexico's 1994 crisis cost almost 10% of GDP. Chile's 1983 crisis was even worse, with the ¯nal cost amounting to a stunning 30% of GDP. Moreover, the economy can experience a traumatic recovery process that in some cases lasts several years. The most common explanation of banking crises focuses on the anticipation of government bail out. This mechanism takes place when investors expect that the government will help them cover their losses in case they face a generalized adverse shock. The paper shows how an insurance scheme eliminates the externality generated by the above government bail out policy. As an example, the paper analyzes the case of liquidity risk, de¯ned as an unexpected cash withdrawal, and it presents a scheme to deal with this risk. This scheme works as an insurance where each bank pays a premium depending on the bank's risk. The scheme used in Argentina where the Central Bank charges to each bank a premium to insurance their liquidity risk, for an insurance which the Central Bank acquires in the international markets is an empirical example. In addition, a new procedure is developed to estimate the social cost of a bank crisis which is di®erent from the net transfer from the government to the banking sector and independent of the existence of the crisis.

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    File URL: http://www.ucema.edu.ar/publicaciones/download/documentos/159.pdf
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    Bibliographic Info

    Paper provided by Universidad del CEMA in its series CEMA Working Papers: Serie Documentos de Trabajo. with number 159.

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    Date of creation: Nov 1999
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    Handle: RePEc:cem:doctra:159

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    1. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    2. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    3. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc.
    4. Mullins, Helena M. & Pyle, David H., 1994. "Liquidation costs and risk-based bank capital," Journal of Banking & Finance, Elsevier, vol. 18(1), pages 113-138, January.
    5. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America," MPRA Paper 13843, University Library of Munich, Germany.
    6. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," MPRA Paper 7125, University Library of Munich, Germany.
    7. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, December.
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