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Bank Panics and the Endogeneity of Central Banking

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  • Gary Gorton
  • Lixin Huang

Abstract

Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with many small, undiversified banks, are prone to panics and failures, unlike systems with a few big banks that are heavily branched and well diversified. Systems of many small banks are more efficient if the banks form coalitions during times of crisis. We provide conditions under which the industrial organization of banking leads to incentive compatible state contingent bank coalition formation. Such coalitions issue money that is a kind of deposit insurance and examine and supervise banks. Bank coalitions of small banks, however, cannot replicate the efficiency of a system of big banks.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9102.

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Date of creation: Aug 2002
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Publication status: published as Gorton, Gary & Huang, Lixin, 2006. "Bank panics and the endogeneity of central banking," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1613-1629, October.
Handle: RePEc:nbr:nberwo:9102

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