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Liquidity Coinsurance, Moral Hazard, and Financial Contagion

  • SANDRO BRUSCO
  • FABIO CASTIGLIONESI

We study the propagation of financial crises among regions in which banks are protected by limited liability and may take excessive risk. The regions are affected by negatively correlated liquidity shocks, so liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky a limited amount of capital is sufficient to prevent risk-taking, but when financial markets are open capital becomes insufficient. Thus, bankruptcy occurs with positive probability and the crisis spreads to other regions via financial linkages. Opening financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk-taking. Copyright 2007 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 62 (2007)
Issue (Month): 5 (October)
Pages: 2275-2302

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Handle: RePEc:bla:jfinan:v:62:y:2007:i:5:p:2275-2302
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  1. Hans Degryse & Grégory Nguyen, 2004. "Interbank exposures: an empirical examination of systemic risk in the Belgian banking system," Working Paper Research 43, National Bank of Belgium.
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