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A Theory of Bank Illiquidity and Default with Hidden Trades

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  • Panetti, Ettore

Abstract

I develop a theory of financial intermediation to explore how the availability of trading opportunities affects the link between the liquidity of financial institutions and their default decisions. In it, banks hedge against liquidity shocks either in the interbank market or by using a costly bankruptcy procedure, and depositors trade in the asset market without being observed. In this environment, the competitive pressure from the asset markets makes intermediaries choose an illiquid asset portfolio. I prove three results. First, illiquid banks default in equilibrium only when there is systemic risk and an unpredicted crisis hits the economy. Second, in contrast to the previous literature, the allocation at default is not socially optimal. Third, the constrained efficient allocation can be decentralized with the introduction of countercyclical liquidity requirements.

Suggested Citation

  • Panetti, Ettore, 2011. "A Theory of Bank Illiquidity and Default with Hidden Trades," MPRA Paper 43799, University Library of Munich, Germany, revised May 2012.
  • Handle: RePEc:pra:mprapa:43799
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    References listed on IDEAS

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    1. Panetti, Ettore, 2011. "Financial liberalization and contagion with unobservable savings," MPRA Paper 29540, University Library of Munich, Germany.
    2. 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.
    3. Heider, F. & Hoerova, M. & Holthausen, C., 2009. "Liquidity Hoarding and Interbank Market Spreads : The Role of Counterparty Risk," Discussion Paper 2009-40 S, Tilburg University, Center for Economic Research.
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    9. Marshall, David A. & Prescott, Edward Simpson, 2006. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2015-2049, November.
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    11. Laurence Ales & Pricila Maziero, "undated". "Non-exclusive Dynamic Contracts, Competition, and the Limits of Insurance," GSIA Working Papers 2010-E59, Carnegie Mellon University, Tepper School of Business.
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    18. repec:eme:sefpps:v:33:y:2016:i:4:p:660-678 is not listed on IDEAS
    19. Viral V. Acharya & Ouarda Merrouche, 2013. "Precautionary Hoarding of Liquidity and Interbank Markets: Evidence from the Subprime Crisis," Review of Finance, European Finance Association, vol. 17(1), pages 107-160.
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    Cited by:

    1. Ettore Panetti, 2016. "Bank Runs: Theories and Policy Applications," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.

    More about this item

    Keywords

    Financial intermediation; bankruptcy; liquidity; hidden trades; insurance; optimal regulation;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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