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An Incentive Problem in the Dynamic Theory of Banking

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  • Ernst-Ludwig VON THADDEN

    (DEEP, University of Lausanne and CEPR)

Abstract

This paper develops a continuous-time model of liquidity provision by banks, in which customers can deposit and withdraw their funds strategically. The strategic withdrawal option introduces an incentive-compatibility problem that turns the problem of designing deposit contracts into a non-standard, non-convex optimal control problem. The paper develops a solution method for this problem and shows that, in this more general frame-work, the insights obtained from the traditional banking models change considerably, up to the point of liquidity provision becoming impossible. The continuous-time framework allows to discuss the problem elegantly and may help to make this part of the banking literature more operational in the sense of modern asset pricing theory.

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Bibliographic Info

Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp25.

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Date of creation: Dec 2000
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Handle: RePEc:fam:rpseri:rp25

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Keywords: Liquidity; deposit contracts; banking; incentive compatibility; continuous time; dynamic programming;

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References

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  1. von Thadden, Ernst-Ludwig, 1998. "Intermediated versus Direct Investment: Optimal Liquidity Provision and Dynamic Incentive Compatibility," Journal of Financial Intermediation, Elsevier, vol. 7(2), pages 177-197, April.
  2. 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.
  3. 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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  20. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  21. 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.
  22. Engineer, Merwan, 1989. "Bank runs and the suspension of deposit convertibility," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 443-454, November.
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Cited by:
  1. Schotter, Andrew & Yorulmazer, Tanju, 2009. "On the dynamics and severity of bank runs: An experimental study," Journal of Financial Intermediation, Elsevier, vol. 18(2), pages 217-241, April.

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