Liquidity Coinsurance, Moral Hazard, and Financial Contagion

Abstract

We study the propagation of financial crises between regions characterized by moral hazard problems. The source of the problem is that banks are protected by limited liability and may engage in excessive risk taking. The regions are affected by negatively correlated liquidity shocks, so that liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky, a limited investment is needed to achieve optimality, so that a limited amount of capital is sufficient to prevent risk-taking. With interbank deposits the optimal investment increases, and capital becomes insufficient to prevent excessive risk-taking. Thus bankruptcy occurs with positive probability and the crises spread to other regions via the financial linkages. Opening the financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk-taking. Finally, we show that in this framework a completely connected deposit structure is more conducive to financial crises than an incompletely connected structure.JEL Classification: G21.

Financial liberalization and contagion with unobservable savings

“…According to that view, financial crises are not the outcome of self-fulfilling prophecies, as in the standard Diamond-Dybvig model, but are consequences of real shocks affecting the economy, that is, an equilibrium outcome. In addition to that, my paper is also related to the literature that rationalizes international transmission of financial shocks through interbank channels, like in Allen and Gale (2000) or Brusco and Castiglionesi (2007). The importance of such approach has been further strengthened by recent empirical analysis of default and contagion in networks of banks (Iyer and Peydró, 2010;Imai and Takarabe, 2011).…”

Financial contagion and depositor monitoring

“…The model builds on Brusco and Castiglionesi (2007). There a three dates (t = 0, 1, 2) and a single good.…”

“…7 As in Brusco and Castiglionesi (2007), the moral hazard problem cannot be solved through contracts, since outside parties cannot observe the investment choice of the bank or the extra return that it produces. 8 We can think that these informed depositors represent large uninsured depositors, that are not completely covered by the insurance fund, as well as other type of credit holders in countries where the institutional and regulatory environment enhance market discipline.…”

“…In particular, we build on the model by Brusco and Castiglionesi (2007), from now on BC, but we modify their framework by introducing the possibility of differently informed depositors. BC analyzed the propagation of financial crises among regions affected by moral hazard problems.…”

“…On the other hand, we follow one strand of the contagion literature that motivates the existence of contagion through the interbank market. A common feature of this literature is that banks have incentives to establish links ex ante, in order to protect themselves against liquidity shocks, but during a crisis, the failure of one institution may have negative effects on other institutions to which it is linked (see Allen and Gale, 2000;Brusco and Castiglionesi, 2007;Castiglionesi, 2007;Hasman and Samartín, 2008). 5 The rest of the paper is organized as follows: the basic model is presented in Section 2.…”