Working Paper: CEPR ID: DP4735
Authors: Hans Gersbach
Abstract: We examine financial intermediation when banks can offer deposit or loan contracts contingent on macroeconomic shocks. We show that the risk allocation is efficient provided there is no workout of banking crises. In this case, banks will shift part of the risk to depositors. In contrast, under a workout of banking crises, depositors receive non-contingent contracts with high interest rates while entrepreneurs obtain loan contracts that demand a high repayment in good times and little in bad times. As a result, the present generation overinvests and banks create large macroeconomic risks for future generations, even if the underlying risk is small or zero.
Keywords: banking; regulation; financial intermediation; macroeconomic risks; state contingent contracts
JEL Codes: D41; E40; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regulator commits to bankruptcy (G33) | Efficient risk allocation (D61) |
| Efficient risk allocation (D61) | All macroeconomic risk borne by entrepreneurs (D89) |
| Bailout regime (G28) | Banks shift macroeconomic risk to depositors (G21) |
| Bailout regime (G28) | Overinvestment by present generation (D15) |
| Overinvestment by present generation (D15) | Substantial risks for future generations (D15) |
| Small underlying risks (D81) | Significant macroeconomic risks under bailout (H12) |
| Presence of capital adequacy rules (G28) | Mitigate excessive risk-taking incentives (G28) |