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Liquidity provision vs. deposit insurance: preventing bank panics without moral hazard

  • Antoine Martin

    ()

In this paper I ask whether a central bank policy of providing liquidity to banks during panics can prevent bank runs without causing moral hazard. This kind of policy has been widely advocated, most notably by Bagehot (1873). I show a particular central bank liquidity provision policy can prevent bank panics without moral hazard problems. I also show that a deposit insurance policy, while preventing runs, can create moral hazard problems. Copyright Springer-Verlag Berlin/Heidelberg 2006

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File URL: http://hdl.handle.net/10.1007/s00199-005-0613-x
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Article provided by Springer in its journal Economic Theory.

Volume (Year): 28 (2006)
Issue (Month): 1 (05)
Pages: 197-211

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Handle: RePEc:spr:joecth:v:28:y:2006:i:1:p:197-211
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  1. Williamson, S.D., 1995. "Discount Window Lending and Deposit Insurance," Working Papers 95-01, University of Iowa, Department of Economics.
  2. Boyd, John H. & Chang, Chun & Smith, Bruce D., 2002. "Deposit insurance: a reconsideration," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1235-1260, September.
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  4. Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
  5. Freeman, Scott, 1988. "Banking as the Provision of Liquidity," The Journal of Business, University of Chicago Press, vol. 61(1), pages 45-64, January.
  6. Haubrich, Joseph G. & King, Robert G., 1990. "Banking and insurance," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 361-386, December.
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  8. Christopher Sleet & Bruce D. Smith, 2000. "Deposit insurance and lender-of-last-resort functions," Proceedings, Federal Reserve Bank of Cleveland, pages 518-579.
  9. von Thadden, Ernst-Ludwig, 1999. "Liquidity creation through banks and markets: Multiple insurance and limited market access," European Economic Review, Elsevier, vol. 43(4-6), pages 991-1006, April.
  10. Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 568-92, June.
  11. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. John Boyd & Chun Chang & Bruce Smith, 2004. "Deposit insurance and bank regulation in a monetary economy: a general equilibrium exposition," Economic Theory, Springer, vol. 24(4), pages 741-767, November.
  13. Denise Hazlett, 1997. "Deposit insurance and regulation in a Diamond-Dybvig banking model with a risky technology (*)," Economic Theory, Springer, vol. 9(3), pages 453-470.
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  15. Russell Cooper & Dean Corbae, 2001. "Financial collapse and active monetary policy: a lesson from the Great Depression," Staff Report 289, Federal Reserve Bank of Minneapolis.
  16. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
  17. V.V. Chari, 1989. "Banking without deposit insurance or bank panics: lessons from a model of the U.S. national banking system," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-19.
  18. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
  19. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  20. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  21. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
  22. Yehning Chen, 1999. "Banking Panics: The Role of the First-Come, First-Served Rule and Information Externalities," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 946-968, October.
  23. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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