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Liquidity Coinsurance, Moral Hazard, and Financial Contagion

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  • SANDRO BRUSCO
  • FABIO CASTIGLIONESI

Abstract

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.

Suggested Citation

  • Sandro Brusco & Fabio Castiglionesi, 2007. "Liquidity Coinsurance, Moral Hazard, and Financial Contagion," Journal of Finance, American Finance Association, vol. 62(5), pages 2275-2302, October.
    • Handle: RePEc:bla:jfinan:v:62:y:2007:i:5:p:2275-2302
    DOI: 10.1111/j.1540-6261.2007.01275.x
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    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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