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Limited enforcement and efficient interbank arrangements

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  • Thorsten V. Koppl
  • James MacGee

Abstract

Banks have historically provided mutual insurance against asset risk, where the insurance arrangement itself was characterized by limited enforcement. This paper shows that a non-trivial interaction between asset and liquidity risk plays a crucial role in shaping optimal banking arrangements in the presence of limited enforcement. We find that liquidity shocks are essential for the provision of insurance against asset shocks, as they mitigate interbank enforcement problems. These enforcement problems generate endogenous aggregate uncertainty as investment allocations depend upon the joint distribution of shocks. Paradoxically, a negative correlation between liquidity and asset shocks ameliorates enforcement limitations and facilitates interbank cooperation.

Suggested Citation

  • Thorsten V. Koppl & James MacGee, 2001. "Limited enforcement and efficient interbank arrangements," Working Papers 608, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmwp:608
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    References listed on IDEAS

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    1. repec:zbw:bofrdp:2001_025 is not listed on IDEAS
    2. 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.
    3. 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.
    4. James MacGee & Thorsten V. Koeppl, 2005. "What Banks Do And Markets Don't: Cross-subsidization," Working Paper 1052, Economics Department, Queen's University.
    5. Korhonen, Tapio, 2001. "Finnish monetary and foreign exchange policy and the changeover to the euro," Research Discussion Papers 25/2001, Bank of Finland.

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    Keywords

    Risk; Liquidity (Economics);

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