Financial liberalization and contagion with unobservable savings

How do market-based channels for the provision of liquidity affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment with unobservable markets for borrowing and lending and comparative advantages in the investment technologies. I demonstrate that the role of hidden markets crucially depends on the level of financial integration of the economy. Despite always imposing a burden on intermediaries, unobservable markets allow agents to partially enjoy gains from financial integration when interbank markets are autarkic. In fully liberalized systems such effect instead disappears. Similarly, in autarky the distortion created by hidden markets improve the resilience of the system to unexpected liquidity shocks. With fully integrated interbank markets, such effect again disappears, as unexpected liquidity shocks always lead to bankruptcy and contagion.financial intermediation, financial liberalization, financial contagion, unobservable savings

Unobservable savings, risk sharing and default in the financial system

In the present paper, I analyze how unobservable savings affect risk sharing and bankruptcy decisions in the financial system. I extend the Diamond and Dybvig (1983) model of financial intermediation to an environment with heterogeneous intermediaries, aggregate uncertainty and agents' hidden borrowing and lending. I demonstrate three results. First, unobservability imposes a burden on financial intermediaries, that in equilibrium are not able to offer a banking contract that balances insurance and incentive motivations. Second, unobservable markets do induce default, but only as long as insurance markets are incomplete. Therefore, their presence is not a rationale for government intervention on bankruptcy via "resolution regimes". Third, even in case of complete markets the competitive equilibrium is inefficient, and a simple tier-1 capital ratio similar to the one proposed in the Basel III Accord implements the efficient allocation.financial intermediation, hidden savings, bankruptcy, insurance, optimal regulation

The European Deposit Insurance Scheme: Economic Rationale, Issues and Policy Solutions

This note summarizes the economic case for completing the European Banking Union with a European Deposit Insurance Scheme (EDIS). The note highlights the role of the EDIS against panic-driven bank runs that might trigger sovereign crises in a doom loop, and spread across the Banking Union via several channels of financial contagion. The main takeaways that we can draw are three. First, the EDIS can be successful only if it acts fast and its commitment to intervene is perceived as credible. Second, there seems to be little evidence that the EDIS could generate an unwarranted cross-subsidization from the less vulnerable to the more vulnerable countries of the Banking Union. Third, there exist several mechanisms to correct bank incentives against the effects of legacy risk and moral hazard that the EDIS might bring about, and some of them are already into place

Financial Liberalization with Hidden Trades

How does the availability of unregulated market-based channels for the circulation of liquidity in the financial system affect the process of financial integration? To answer this question, I develop a two-country model of banking, where the banks have access to country-specific investment technologies, and agents can borrow and lend liquidity in a hidden market. I characterize the competitive equilibria at different levels of integration (both in the banking system and in the hidden market) and show that the only level of integration which the two countries are able to coordinate is the one where the two banking systems are autarkic, but international hidden trades are possible. In contrast to the previous literature, I also find that the resulting consumption allocation is constrained efficient

The welfare costs of self-fulfilling bank runs

We study the welfare implications of self-fulfilling bank runs and liquidity require- ments, in a neoclassical growth model where banks, facing long-lasting possible runs, can choose in any period a run-proof asset portfolio. In this framework, runs distort banks’ insurance provision against idiosyncratic liquidity shocks, and liquidity requirements resolve this distortion by forcing a credit tightening. Quantitatively, the welfare costs of self-fulfilling bank runs are equivalent to a constant consumption loss of up to 2.5 percent of U.S. GDP. Depending on fundamentals, liquidity requirements might generate small welfare gains, but also increase the welfare costs by up to 1.8 percent.info:eu-repo/semantics/publishedVersio

Wealth inequality, systemic financial fragility and government intervention

Does wealth inequality make financial crises more likely? If so, how can a government intervene, and how does this affect the distribution of resources in the economy? To answer these questions, we study a banking model where strategic complementarities among wealth-heterogeneous depositors trigger systemic self-fulfilling runs. In equilibrium, higher wealth inequality increases directly the incentives to run of the poor, and indirectly those of the rich via higher bank liquidity insurance, thus increasing the probability of a systemic self-fulfilling run overall. A government intervention on illiquid but solvent banks redistributes resources towards the poor and makes systemic self-fulfilling runs less likely

Financial liberalization and contagion with unobservable savings

How do market-based channels for the provision of liquidity affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment with unobservable markets for borrowing and lending and comparative advantages in the investment technologies. I demonstrate that the role of hidden markets crucially depends on the level of financial integration of the economy. Despite always imposing a burden on intermediaries, unobservable markets allow agents to partially enjoy gains from financial integration when interbank markets are autarkic. In fully liberalized systems such effect instead disappears. Similarly, in autarky the distortion created by hidden markets improve the resilience of the system to unexpected liquidity shocks. With fully integrated interbank markets, such effect again disappears, as unexpected liquidity shocks always lead to bankruptcy and contagion

Financial liberalization and contagion with unobservable savings

How do market-based channels for the provision of liquidity affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment with unobservable markets for borrowing and lending and comparative advantages in the investment technologies. I demonstrate that the role of hidden markets crucially depends on the level of financial integration of the economy. Despite always imposing a burden on intermediaries, unobservable markets allow agents to partially enjoy gains from financial integration when interbank markets are autarkic. In fully liberalized systems such effect instead disappears. Similarly, in autarky the distortion created by hidden markets improve the resilience of the system to unexpected liquidity shocks. With fully integrated interbank markets, such effect again disappears, as unexpected liquidity shocks always lead to bankruptcy and contagion

A Theory of Bank Illiquidity and Default with Hidden Trades

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