Banks as Liquidity providers Flashcards

1
Q

What is the structure of the Diamond-Dybvig Model?

A
  • Three period
  • One homogenous good consumed either in first or second period: c_1,c_2
  • Individuals → initial endowment of unit 1 in T = 0
  • Individuals can either store endowment or invest in project characterized by long-term production technology
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2
Q

How is the production technology defined?

A

Production technology requires investment in T = 0

• Yields R > 1 in T = 2 for each unit invested

Or

• Returns liquidation value equal to initial investment when production aborted in T = 1

Intuition: LT investments irreversible and liquidating early may result in losses

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3
Q

What are the two types of individuals?

A

Individuals identical in T = 0 but in T = 1 learn in private whether type 1 or type 2

  • Type 1: early consumers and only car about c_1
  • Type 2: patient and care about c_2

Intuition: Individuals face private and stochastically independent risk of sudden liquidity needs

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4
Q

What is the intuition behind the First Best assumption?

A

Individuals share risk of being early consumer optimally

  • Exante: individuals smooth consumption across states
  • Expost: type 1/2 is better/worse off than under autarky
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5
Q

What happens under optimal risk sharing when it cannot be achieved via financial markets?

A
  • Claims only contingent on publicly available and verifiable information
  • But optimal risk sharing require claims contingent on type-membership which = private information

→ Contingent claims allowing for optimal risk sharing are unavailable in financial markets

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6
Q

What happens under optimal risk sharing when it cannot be achieved using self-selection of types?

A

Financial intermediary offer contract based on self.seletion of types that achieves optimal risk sharing

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7
Q

What is the sequential service constraint?

A

Depositors willing to withdraw = served in sequential order they appear at bank’s desk

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8
Q

How is it possible that the demand deposit contract achieves optimal risk sharing ?

A
  • Risk t of being of type 1 = stochastically independent
  • According to law of large numbers the share of early withdrawers bank faces very close to t

→ bank can stay solvent while engaging in maturity transformation

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9
Q

What happens if the bank invest the rest in illiquid assets ?

A

It renders bank illiquid = cannot serve more than expected t early without liquidating assets.

→ equilibrium relies entirely on type 2 not withdrawing early
→banks inherently fragile and prone to liquidity risk

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10
Q

What happens when some type 2 lose confidence and withdraw early ?

A

• Bank pays them c_1* in sequential order (liquidation value smaller than actual payout so bank = insolvent)

→ All individuals run and try to withdraw as early as possible since latecomers get nothing
→ Great economic damage: all investments liquidated = output lower than under autarky

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11
Q

What is the intuition behind bank run equilibrium?

A

Type 2 face coordination problem:

  • Either none withdraws early = efficient equilibrium with optimal risk sharing
  • All withdraw early = inefficient equilibrium with bank run

→ Even weak signals can cause loss of confidence and switch from efficient to inefficient equilibrium
→ Bank run may spread easily throughout whole banking system

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12
Q

What is narrow banking ?

A

Requires bank to hold enough liquidity to withstand bank run

→ Runs never occur
→ Drawback: Benefits from maturity transformation eliminated and optimal risk sharing no longer possible

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13
Q

What are the various techniques to avoid bank runs?

A
  • Suspension of convertibility
  • Deposit insurance
  • Lending of last resort
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14
Q

What is suspension of convertibility?

A

Bank pay out at most tc_1* in T = 1

  • Only first t depositors can withdraw early
  • Bank can surely meet obligations in T = 2

→ removes incentive of type 2 to run
→ drawback: It random, some type 1 may not be able to withdraw

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15
Q

What is deposit insurance?

A

Guarantees promised return to all who withdraw even if bank fails

• Removes sequential service constraint as payouts independent of depositors’ place in line
→ type 2 no incentive to run

• government natural provider of deposit insurance due to ability to tax

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16
Q

What is the lending of last resort?

A

Central bank provides unlimited liquidity against good collateral

• Banks can obtain emergency loans from CB using illiquid assets as collateral
→ Prevents liquidation of assets

• Depositors know CB provides sufficient liquidity when needed
→ Type 2 no incentive to run

17
Q

What are the drawbacks of safety nets ?

A

• Full insurance = depositors indifferent about banks’ risk
→ market discipline breaks down

• Banks incentive to take higher risks
→ Privatize profits, socialize losses

18
Q

What is the repo ?

A

• Major source of ST finance
o Sale of securities with agreement ot purchase back at later date for predefined repurchasing price
o Repurchasing price higher than initial selling price implying an interest rate = repo rate

  • Traded security = collateral to mitigate credit risk
  • Securities’ quality defines haircut
19
Q

What does the DD model not explain ?

A

• Standard loan contract and banks’ role as loan providers
→ focus on banks’ liabilities

• Coexistence of banks and markets
→ Introduction of financial market destroys risk sharing contract offered by banks