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What assets should banks be allowed to hold?

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  • V.V. Chari
  • Christopher Phelan

Abstract

Banks are vulnerable to self-fulfilling panics because their liabilities (such as demand deposits and certificates of deposit) are short term and unconditional, and their assets (such as mortgages and business loans) are long term and illiquid. To prevent wider financial fallout from such panics, governments have strong incentive to bail out bank debtholders. Paradoxically, expectations of such bailouts can lead financial systems to rely excessively—from a societal perspective—on short-term debt to fund long-term assets. Fragile banking systems thus impose external costs, and regulation may therefore be socially desirable. ; In light of this fragility and cost, we examine two of the major theoretical benefits from the reliance of the banking system on short-term debt: (1) maturity transformation and (2) efficient monitoring of bank managers. We argue that while both justifications may be compelling, they point us to financial regulations very different from the ones currently in place. These theoretical justifications suggest that the assets funded by banks should not have close substitutes in publicly traded markets, as is currently the case.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Economic Policy Paper with number 12-3.

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Date of creation: 2012
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Handle: RePEc:fip:fedmep:12-3

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  1. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
  2. 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.
  3. Chari, V V & Jagannathan, Ravi, 1988. " Banking Panics, Information, and Rational Expectations Equilibrium," Journal of Finance, American Finance Association, vol. 43(3), pages 749-61, July.
  4. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
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Cited by:
  1. V.V. Chari & Christopher Phelan, 2012. "The "banks" we do need," Economic Policy Paper 13-1, Federal Reserve Bank of Minneapolis.

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