Working Paper: CEPR ID: DP15884
Authors: Hans Gersbach
Abstract: What happens when banks compete with deposit and loan contracts contingent on macroeconomic shocks? We show that the private sector insures the banking system efficiently against banking crises through such contracts when banks focus on expected profit maximization and failing banks go bankrupt. When risks are large, banks may shift part of the risk to depositors who receive state-contingent contracts. Repackaging of the risk among depositors can improve welfare. In contrast, when failing banks are rescued, new phenomena such as risk creation or magnification emerge, which would not occur with non-contingent contracts. In particular, depositors receive non-contingent contracts with comparatively high interest rates, while entrepreneurs obtain loan contracts that demand high repayment in good times and low repayment in bad times. As a result, banks overinvest and generate large macroeconomic risks, even if the underlying productivity risk is small or zero.
Keywords: financial intermediation; macroeconomic risks; state-contingent contracts; banking regulation
JEL Codes: D41; E4; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| contingent contracts (D86) | efficient insurance against banking crises (F65) |
| bailouts (H81) | risk creation or magnification (H84) |
| non-contingent contracts (D86) | high interest rates for depositors (E43) |
| contingent contracts (D86) | new risks (D81) |
| bailouts (H81) | preference for non-contingent deposit contracts (G19) |
| bailouts (H81) | preference for contingent loan contracts (D86) |
| banks' focus on expected profit maximization (L21) | improved welfare (I30) |
| macroeconomic shocks (F41) | implications for banking system stability (F65) |