Ebook Liquidity, moral hazard and bank runs
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)) efficient risk-sharing between depositors with idiosyncratic, privately observed taste shocks creates a demand for liquidity. Banks invest in illiquid assets but take on liquid liabilities by issuing demand deposit contracts with a sequential service constraint. Although demand deposit contracts support the efficient risk-sharing between depositors, the use of such contracts makes banks vulnerable to runs driven by depositor coordination failure.
However, as Diamond and Dybvig point out, when aggregate taste shocks are common knowledge, a demand deposit contract with an appropriately chosen threshold for suspension of convertibility eliminates bank runs while supporting efficient risk-sharing. This result raises the following question: without any a priori restrictions on banking contracts, are there scenarios where equilibrium bank runs occur with positive probability in a banking contract?
This paper studies the connection between the possible misalignment of the incentives of the bank and depositors, and the role of bank runs as a disciplining device. We study a model of banking with moral hazard but without aggregate payoff-relevant uncertainty. In our model, the bank has no investment funds of its own but has a comparative advantage in operating illiquid assets: no other agent in the economy has the human capital to operate illiquid assets. Consequently, the bank controls any investment made in illiquid assets. The bank has a choice of two illiquid assets to invest in. After depositors endowments have been mobilized, but before the realization of idiosyncratic taste shocks, the bank makes an investment decision. Each illiquid asset generates a stream of “public” and “private” returns. We think of "public" returns as cash flows generated by the asset that the bank cannot access without depositors’ consent (for instance, such cash flows are generated by physical capital which can be monitored and seized by depositors). "Private" returns, then, are cash flows generated by the asset which can be accessed by the bank without depositors’ consent.
Consider first the case when depositors have all the bargaining power. Even with costless, perfect monitoring of the banks actions, we show that using transfers to provide the bank with appropriate incentives can result in narrow banking and no liquidity provision. More generally, incentive compatible transfers to the bank will lower consumption for all types of depositors. Nevertheless, our first result shows that it is still possible to implement efficient risk sharing between depositors, without sacrificing consumption, by using a contract which embodies the threat of a bank run off the equilibrium path of play.
When the investment decision of the bank is non-contractible, we show that efficient risk-sharing between depositors is no longer implementable. Even with forward looking depositors, the positive probability of an equilibrium bank run is necessary and sufficient to resolve incentive problems in banking. Although the second-best incentive compatible contract improves on autarky, it also generates, endogenously, the risk of a banking crisis.
Next, we note that when the bank has all the bargaining power and is able to appropriate both public and private returns generated by assets, there is productive efficiency (the bank invests all mobilized deposits in the asset with highest combined public and private return) but narrow banking and no liquidity provision (equivalently, efficient risk-sharing between depositors).
Reverting to the assumption that the depositors have all the bargaining power, we extend the model in two ways, first, by studying more general monitoring scenarios and second, by allowing the use of collaterals in banking. With costly but perfect monitoring, the trade-off between risk-sharing between depositors and providing appropriate incentives to the bank, continues to apply. With costly and imperfect monitoring, we show that the threat of bank runs off-the-equilibrium path of play and equilibrium bank runs, are both features of a banking contract.
Next, we study a different monitoring scenario where all monitoring takes place conditional on a bank run. In such situations, we show that positive probability of bank runs and monitoring along the equilibrium path of play are essential features of an incentive compatible contract. Our results rationalize the sequence of events involved in such interventions (temporary bailout measures, followed by a discovery phase and finally, a restructuring phase).
We then extend the model to scenarios where a small portion of the bank’s non-contractible payoffs can be seized by an outside agent (a court). In such scenarios, we show that random demandable debt contracts studied here Pareto improve on autarchy. As there is no aggregate uncertainty in preferences and technology, the randomness introduced by banking contracts studied here is uncorrelated with fundamentals and is driven purely by incentives. We believe this is a more primitive explanation for bank runs. In the formal model studied here, bailouts are equivalent to building in a suspension of convertibility clause in the banking contract. In this sense, the random second-best contract studied here provides a rationale for the doctrine of "creative ambiguity" when the banking regulator makes no ex-ante commitment to a particular bailout policy but instead leaves the banking sector in doubt about its intentions (Goodhart (1999)). When all monitoring takes place conditional on a bank run, as both bank runs and monitoring are triggered by payoff irrelevant uncertainty, our results provide a further justification for the doctrine of "creative ambiguity".
The rest of the paper is structured as follows. The remainder of the introduction relates the results obtained here with other papers on bank runs. Section 2 studies a simple model of banking with moral hazard and leads up to the main result of the paper. Section 3 is devoted to robustness issues. The final section concludes.
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