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

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  • Antoine Martin

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). To analyze such a policy, I build a model with three key features: 1) bank panics can occur in equilibrium, 2) there can be moral hazard, 3) the central bank can create money which is willingly held. I show that a particular central bank repurchase policy provides liquidity to the banking system and can prevent bank panics without moral hazard problems. I also show that a deposit insurance policy, while preventing runs, creates moral hazard problems.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 01-05.

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Date of creation: 2001
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Handle: RePEc:fip:fedkrw:rwp01-05

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Keywords: Deposit insurance ; Liquidity (Economics);

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  1. 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.
  2. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
  3. 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.
  4. Champ, B. & Snith, B.D. & Williamson, D.S., 1991. "Currency Elasticity and Banking Panics: Theory and Evidence," RCER Working Papers 292, University of Rochester - Center for Economic Research (RCER).
  5. Lucas, Robert E, Jr & Stokey, Nancy L, 1987. "Money and Interest in a Cash-in-Advance Economy," Econometrica, Econometric Society, vol. 55(3), pages 491-513, May.
  6. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. Stephen D. Williamson, 1995. "Discount Window Lending and Deposit Insurance," Macroeconomics 9504001, EconWPA, revised 18 Apr 1995.
  12. Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
  13. Joseph G. Haubrich & Robert G. King, 1984. "Banking and Insurance," NBER Working Papers 1312, National Bureau of Economic Research, Inc.
  14. 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.
  15. 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.
  16. 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.
  17. von Thadden, Ernst-Ludwig, 1999. "Liquidity creation through banks and markets: Multiple insurance and limited market access," European Economic Review, Elsevier, vol. 43(4-6), pages 991-1006, April.
  18. 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.
  19. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  20. Freeman, Scott, 1988. "Banking as the Provision of Liquidity," The Journal of Business, University of Chicago Press, vol. 61(1), pages 45-64, January.
  21. 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.
  22. 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.
  23. 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.
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