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An Incentive Problem in the Dynamic Theory of Banking

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  • Ernst-Ludwig VON THADDEN

    (DEEP, University of Lausanne and CEPR)

Abstract

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.

Suggested Citation

  • Ernst-Ludwig VON THADDEN, 2000. "An Incentive Problem in the Dynamic Theory of Banking," FAME Research Paper Series rp25, International Center for Financial Asset Management and Engineering.
  • Handle: RePEc:fam:rpseri:rp25
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    References listed on IDEAS

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    Cited by:

    1. Schotter, Andrew & Yorulmazer, Tanju, 2009. "On the dynamics and severity of bank runs: An experimental study," Journal of Financial Intermediation, Elsevier, vol. 18(2), pages 217-241, April.

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    More about this item

    Keywords

    Liquidity; deposit contracts; banking; incentive compatibility; continuous time; dynamic programming;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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