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On the Stability of Different Financial Systems

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  • Falko Fecht

Abstract

An economy in which deposit-taking banks of a Diamond and Dybvig style and a financial market coexist is modeled in a simple framework closely related to Diamond (1997). Solely depending on the fraction of naïve households who cannot efficiently invest directly in the cor-porate sector, two different types of financial systems emerge. With the fraction comparatively low, the evolving financial system can be interpreted as market-oriented, whereas a high frac-tion brings about a bank-dominated financial system. In market-oriented systems, banks only provide naïve households with access to efficient investments; in bank-dominated systems, banks' deposit contracts also offer some degree of liquidity insurance. Consequently, com-pared to market-oriented financial systems, the household sector in bank-dominated financial systems holds a larger portfolio fraction in deposits and a smaller part in direct investments. Analyzing the resilience of the different financial systems to various types of shocks shows that moderately bank-dominated (or hybrid) financial systems are particularly fragile, because only in these systems do fire sales of assets by distressed banks cause a deterioration in asset prices that also precipitates other banks into crisis. (JEL: D52, E44, G10, G21) Copyright (c) 2004 by the European Economic Association.

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Paper provided by Department of Finance, Goethe University Frankfurt am Main in its series Working Paper Series: Finance and Accounting with number 110.

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Date of creation: 2003
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Handle: RePEc:fra:franaf:110

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  1. X. Freixas & B. Parigi & J-C. Rochet, 2000. "Systemic Risk, Interbank Relations and Liquidity Provision by theCentral Bank," DNB Staff Reports (discontinued) 47, Netherlands Central Bank.
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  5. Schmidt, Reinhard H. & Hackethal, Andreas & Tyrell, Marcel, 1999. "Disintermediation and the Role of Banks in Europe: An International Comparison," Journal of Financial Intermediation, Elsevier, vol. 8(1-2), pages 36-67, January.
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  7. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Douglas W. Diamond & Raghuram G. Rajan, 1999. "A Theory of Bank Capital," NBER Working Papers 7431, National Bureau of Economic Research, Inc.
  9. Alexandra Lai, 2002. "Modelling Financial Instability: A Survey of the Literature," Working Papers 02-12, Bank of Canada.
  10. Mathias Dewatripont & Philippe Aghion & Patrick Bolton, 2000. "Contagious bank failures in a free banking system," ULB Institutional Repository 2013/9737, ULB -- Universite Libre de Bruxelles.
  11. Franklin Allen & Douglas Gale, 2001. "Comparative Financial Systems: A Survey," Center for Financial Institutions Working Papers 01-15, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. Luigi Zingales & Raghuram G. Rajan, 2003. "Banks and Markets: The Changing Character of European Finance," NBER Working Papers 9595, National Bureau of Economic Research, Inc.
  13. 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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