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An incentive problem in the dynamic theory of banking

  • von Thadden, Ernst-Ludwig

This paper develops a continuous-time model of liquidity provision by banks, in which customers can deposit and withdraw their funds strategically. The strategic withdrawal option introduces an incentive-compatibility problem that turns the problem of designing deposit contracts into a non-standard, non-convex optimal control problem. The paper develops a solution method for this problem and shows that, in this more general frame-work, the insights obtained from the traditional banking models change considerably, up to the point of liquidity provision becoming impossible. The continuous-time framework allows to discuss the problem elegantly and may help to make this part of the banking literature more operational in the sense of modern asset pricing theory.

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Article provided by Elsevier in its journal Journal of Mathematical Economics.

Volume (Year): 38 (2002)
Issue (Month): 1-2 (September)
Pages: 271-292

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Handle: RePEc:eee:mateco:v:38:y:2002:i:1-2:p:271-292
Contact details of provider: Web page: http://www.elsevier.com/locate/jmateco

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