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Risky collateral and deposit insurance

Author

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  • Narayana R. Kocherlakota

Abstract

This paper provides a new rationalization for deposit insurance and systemic disintermediations. I consider an environment in which borrowers face no penalty for failing to repay obligations except the loss of their collateral. I assume that this collateral has aggregate risk. For a subset of the exogenous parameters, I demonstrate that an optimal arrangement features deposit insurance. For a strictly smaller set of parameters, it is optimal in some states of the world to have systemic disintermediation and concomitant falls in real output.

Suggested Citation

  • Narayana R. Kocherlakota, 2000. "Risky collateral and deposit insurance," Staff Report 274, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:274
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    References listed on IDEAS

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    1. Jeffrey Lacker, 2001. "Collateralized Debt as the Optimal Contract," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 842-859, October.
    2. Oliver Hart & John Moore, 1998. "Default and Renegotiation: A Dynamic Model of Debt," The Quarterly Journal of Economics, Oxford University Press, vol. 113(1), pages 1-41.
    3. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    4. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    5. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated insurance relationships in a costly state verification model: With an application to deposit insurance," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 207-240, July.
    6. Fernando Alvarez & Urban J. Jermann, 1998. "Asset Pricing when Risk Sharing is Limited by Default," NBER Working Papers 6476, National Bureau of Economic Research, Inc.
    7. Timothy J. Kehoe & David K. Levine, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 865-888.
    8. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
    9. Jeffrey Lacker, 2001. "Collateralized Debt as the Optimal Contract," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 842-859, October.
    10. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    11. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    12. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-16.
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    Citations

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    Cited by:

    1. Arellano, Cristina & Kocherlakota, Narayana, 2014. "Internal debt crises and sovereign defaults," Journal of Monetary Economics, Elsevier, vol. 68(S), pages 68-80.
    2. Ewerhart, Christian & Tapking, Jens, 2008. "Repo markets, counterparty risk and the 2007/2008 liquidity crisis," Working Paper Series 909, European Central Bank.
    3. Charles M. Kahn & William Roberds, 2002. "Payments settlement under limited enforcement: Private versus public systems," FRB Atlanta Working Paper 2002-33, Federal Reserve Bank of Atlanta.
    4. Shengxing Zhang, 2014. "Collateral Risk, Repo Rollover and Shadow Banking," 2014 Meeting Papers 562, Society for Economic Dynamics.
    5. Koeppl, Thorsten V. & MacGee, James C., 2009. "What broad banks do, and markets don't: Cross-subsidization," European Economic Review, Elsevier, vol. 53(2), pages 222-236, February.
    6. Thorsten Koeppl & James MacGee, 2005. "What Banks Do and Markets Don't: Cross-subsidization," Working Papers 1052, Queen's University, Department of Economics.
    7. Thorsten V. Koppl & James MacGee, 2001. "Limited enforcement and efficient interbank arrangements," Working Papers 608, Federal Reserve Bank of Minneapolis.
    8. Kahn, Charles M. & Roberds, William, 2009. "Why pay? An introduction to payments economics," Journal of Financial Intermediation, Elsevier, vol. 18(1), pages 1-23, January.
    9. Federico Lubello & Ivan Petrella & Emiliano Santoro, 2018. "Chained financial frictions and credit cycles," BCL working papers 116, Central Bank of Luxembourg.

    More about this item

    Keywords

    Deposit insurance ; Contracts;

    JEL classification:

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

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