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Liquidity Coinsurance, Moral Hazard and Financial Contagion

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Author Info
Sandro Brusco () (Department of Economics, SUNY at Stony Brook)
Fabio Castiglionesi () (Departament d’ Economia, Universitat Autònoma de Barcelona. E-mail:)

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Abstract

We study the propagation of financial crises between regions characterized by moral hazard problems. The source of the problem is that banks are protected by limited liability and may engage in excessive risk taking. The regions are affected by negatively correlated liquidity shocks, so that liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky, a limited investment is needed to achieve optimality, so that a limited amount of capital is sufficient to prevent risk-taking. With interbank deposits the optimal investment increases, and capital becomes insufficient to prevent excessive risk-taking. Thus bankruptcy occurs with positive probability and the crises spread to other regions via the financial linkages. Opening the financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk-taking. Finally, we show that in this framework a completely connected deposit structure is more conducive to financial crises than an incompletely connected structure.

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File URL: http://www.sunysb.edu/economics/research/papers/2005/brucast.pdf
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File Function: First version, 2005
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Publisher Info
Paper provided by Stony Brook University, Department of Economics in its series Department of Economics Working Papers with number 05-12.

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Date of creation: Jul 2005
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Handle: RePEc:nys:sunysb:05-12

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Related research
Keywords: Moral Hazard; Liquidity Coinsurance; Contagion.;

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Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 111-28, February.
  2. Laura E. Kodres & Matthew Pritsker, 2002. "A Rational Expectations Model of Financial Contagion," Journal of Finance, American Finance Association, vol. 57(2), pages 769-799, 04. [Downloadable!] (restricted)
  3. Xavier Freixas & Bruno M. Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, pages 611-640.
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  4. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
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  5. Albert S. Kyle, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, 08. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research. [Downloadable!]
  2. Wagner, Wolf, 2006. "Diversification at financial institutions and systemic crises," Discussion Paper 71, Tilburg University, Center for Economic Research. [Downloadable!]
  3. Kleopatra Nikolaou, 2009. "Liquidity (risk) concepts - definitions and interactions," Working Paper Series 1008, European Central Bank. [Downloadable!]
  4. Mardi Dungey & George Milunovich & Susan Thorp, 2008. "Unobservable Shocks as Carriers of Contagion: A Dynamic Analysis Using Identified Structural GARCH," NCER Working Paper Series 22, National Centre for Econometric Research. [Downloadable!]
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