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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. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
  2. Gary Gorton & Andrew Winton, 2002. "Financial Intermediation," NBER Working Papers 8928, National Bureau of Economic Research, Inc.
  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. Allen, Franklin & Gale, Douglas, 1995. "A welfare comparison of intermediaries and financial markets in Germany and the US," European Economic Review, Elsevier, vol. 39(2), pages 179-209, February.
  5. 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.
  6. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  7. 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.
  8. 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.
  9. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. 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.
  11. Todd Keister & Huberto Ennis, 2012. "Optimal banking contracts and financial fragility," 2012 Meeting Papers 179, Society for Economic Dynamics.
  12. 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.
  13. Joseph G. Haubrich & Robert G. King, 1984. "Banking and Insurance," NBER Working Papers 1312, National Bureau of Economic Research, Inc.
  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. Edward J. Green & Ping Lin, 1996. "Implementing efficient allocations in a model of financial intermediation," Working Papers 576, Federal Reserve Bank of Minneapolis.
  16. 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.
  17. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  18. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2007. "A Theory of Liquidity and Regulation of Financial Intermediation," NBER Working Papers 12959, National Bureau of Economic Research, Inc.
  19. Alonso, Irasema, 1996. "On avoiding bank runs," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 73-87, February.
  20. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
  21. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  22. 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.
  23. Jean Tirole, 2011. "Illiquidity and All Its Friends," Journal of Economic Literature, American Economic Association, vol. 49(2), pages 287-325, June.
  24. 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.
  25. 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.
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