On the fundamental reasons for bank fragility

Economic Quarterly 01/2010; 96(1Q):33-58.
Source: RePEc


A substantial body of literature has now developed as a result of efforts to identify the fundamental reasons for the fragility of financial intermediaries in the Diamond-Dybvig theory of banking. Many of these articles focus on the interaction between sequential service and uncertainty about the aggregate need for liquidity in the economy. The articles in this literature are inevitably technical and focus somewhat narrowly on the implications of specific assumptions. Here, we provide a more accessible discussion of the main ideas and findings in this literature. Our discussion can be used as an introduction to the more technical articles or as an organizing framework for understanding the relative contribution of the main articles in this literature.

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    • "For instance, warehousing in step 2 is done through dedicated entities (for instance, the ABCP conduits mentioned earlier) that finance the acquisition of the long-term assets through the issuance of shorter-term liabilities. Because of the implied maturity transformation that this role involves, this stage would typically require the provision of some form of liquidity and credit enhancement—for the same reason that banks' traditional 3 See, for example, Ennis and Keister (2010) "
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    ABSTRACT: This is the introduction to a volume which explores the changing role of banks in the financial intermediation process. It accompanies a Liberty Street Blog series. Both discuss the complexity of the credit intermediation chain associated with securitization and note the growing participation of nonbank entities within it. These series also discuss implications for monitoring and rulemaking going forward. In the introduction, Nicola Cetorelli introduces the series and provides a preview of the topics covered. Additionally, he lays out the overarching theme of the volume—the fact that banks continue to be major players in the modern credit intermediation system.
    Preview · Article · Jan 2012
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    ABSTRACT: We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the (constrained) efficient allocation of resources in closed-form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies. JEL Classification Numbers: G21,G01, D82 We thank seminar participants at the University of Iowa, the Federal Reserve Bank of Richmond, and 2010 Winter Meetings of the Econometric Society for useful comments. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve Bank of Richmond, or the Federal Reserve System.
    Preview · Article · Aug 2015 · Economic Theory
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    ABSTRACT: Sequential service in the banking sector, as modeled by Diamond and Dybvig (1983), is a barrier to full insurance and potential source of financial fragility against which deposit insurance is infeasible (Wal-lace, 1988). In this paper, we pursue a different perspective, view-ing the sequence of contacts as opportunities to extract information through a larger message space with commitment to richer promises. As we show, if preferences satisfy a separating property then the de-sired elimination of dominated strategies (Green and Lin, 2003) occurs even when shocks are correlated. In this manner the sequential service promotes stability.
    Preview · Article · Mar 2011 · Economic Theory
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