Liquidity, moral hazard and bank runs - University of Warwick.pdfVIP

Liquidity, moral hazard and bank runs ¤ S.Chatterji and S.Ghosal, Centro de Investigacion Economica, ITAM, and University of Warwick September 13, 2007 Abstract In a model of banking with moral hazard, e¢cient risk-sharing be- tween depositors may no longer be implementable. When depositors have all the bargaining power, we show that (i) with costless and perfect mon- itoring, contracts with the threat of bank runs o¤ the equilibrium path of play improve on contracts with transfers, (ii) when the bank’s actions are non-contractible, equilibrium bank runs driven by incentives are linked to liquidity provision by banks. When the bank has all the bargaining power, there is production e¢ciency but no liquidity provision to depos- itors. The model is extended to allow for general monitoring scenarios and partial contractibility of the bank’s payo¤s. Our results provide a theoretical foundation for the doctrine of creative ambiguity . JEL classi… cation numbers: G21, D82. Key words: bank runs, moral hazard, risk-sharing, liquidity, random, contracts. ¤We would like to thank Marcus Miller, Eugenio Proto, Kostas Koufopoulos and Tridib Sharma for their helpful comments. Contact details: shurojit@itam.mx, S.Ghosal@warwick.ac.uk. 1 1 Introduction A key issue in the theoretical literature on banking is the link between illiquid assets, liquid liabilities and bank runs. In the seminal paper by Diamond and Dybvig (1983) (see also Bryant (1980)) e¢cient risk-sharing between deposi- tors with idiosyncratic, privately observed taste shocks creates a demand for liquidity. Banks invest in illiquid assets but take o