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Optimal Intermediation Under Aggregate Consumption Uncertainty

  • Ioannis Lazopoulos

    (University of Surrey)

The paper develops a banking framework where a welfare comparison is made between non-tradable demand deposit and equity contracts. Contrary to the existing literature that relies heavily on smooth preferences assumption to justify the liquidity insurance superiority of the ‘run-prone’ debt contracts over the ‘run-free’ equity contracts, the paper shows that when aggregate consumption uncertainty is introduced, the welfare dominance of deposit contracts emerges for a simpler preference structure as deposit contracts offer more risk-sharing opportunities. The model illustrates that such uncertainty creates a high dispersion between the allocations that can be attained by trading in the secondary market, and therefore the equity contract provides ex ante less risk-sharing to risk-averse consumers than a tailored-made debt contract.

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File URL: http://www.fahs.surrey.ac.uk/economics/discussion_papers/2010/DP07-10.pdf
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Paper provided by School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0710.

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Length: 34 pages
Date of creation: Sep 2010
Date of revision:
Handle: RePEc:sur:surrec:0710
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  1. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  2. Huberto M. Ennis & Todd Keister, 2010. "On the fundamental reasons for bank fragility," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 33-58.
  3. Andolfatto, David & Nosal, Ed & Wallace, Neil, 2007. "The role of independence in the Green-Lin Diamond-Dybvig model," Journal of Economic Theory, Elsevier, vol. 137(1), pages 709-715, November.
  4. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
  5. Gorton, Gary & Winton, Andrew, 2003. "Financial intermediation," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, pages 431-552 Elsevier.
  6. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-56, October.
  7. 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.
  8. Edward J. Green & Ping Lin, 1996. "Implementing efficient allocations in a model of financial intermediation," Working Papers 576, Federal Reserve Bank of Minneapolis.
  9. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  10. Tirole, Jean, 2009. "Illiquidity and All Its Friends," TSE Working Papers 09-083, Toulouse School of Economics (TSE), revised Feb 2010.
  11. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2008. "A Theory of Liquidity and Regulation of Financial Intermediation," Levine's Working Paper Archive 122247000000002006, David K. Levine.
  12. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  13. Alonso, Irasema, 1996. "On avoiding bank runs," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 73-87, February.
  14. J. Huston McCulloch & Min-Teh Yu, 1998. "Government Deposit Insurance and the Diamond-Dybvig Model," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 23(2), pages 139-149, December.
  15. Gertler, Mark & Kiyotaki, Nobuhiro, 2010. "Financial Intermediation and Credit Policy in Business Cycle Analysis," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 11, pages 547-599 Elsevier.
  16. Franklin Allen & Douglas Gale, 2005. "From Cash-in-the-Market Pricing to Financial Fragility," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 535-546, 04/05.
  17. Ennis, Huberto M. & Keister, Todd, 2009. "Run equilibria in the Green-Lin model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1996-2020, September.
  18. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
  19. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
  20. Franklin Allen & Douglas Gale, 1994. "A welfare comparison of intermediaries and financial markets in Germany and the U.S," Working Papers 95-3, Federal Reserve Bank of Philadelphia.
  21. 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.
  22. Haubrich, Joseph G. & King, Robert G., 1990. "Banking and insurance," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 361-386, December.
  23. Jianping Qi, 2003. "Liquidity Provision, Interest-Rate Risk, and the Choice between Banks and Mutual Funds," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 159(3), pages 491-, September.
  24. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  25. Todd Keister & Huberto Ennis, 2012. "Optimal banking contracts and financial fragility," 2012 Meeting Papers 179, Society for Economic Dynamics.
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