Working Paper: CEPR ID: DP7304
Authors: Max Bruche; Javier Suarez
Abstract: This paper develops a tractable general equilibrium model in which money markets provide structural funding to some banks. When bank default risk becomes significant, retail deposit insurance creates an asymmetry between banks that operate in savings-rich regions, which can remain financed at cheap risk-free rates, and in savings-poor regions, which have to pay either large spreads in money markets or high rates for the scarce regional savings. We show that this asymmetry can cause a severe distortion of the aggregate allocation of credit. When interdependencies across borrowers are large (e.g., via demand externalities), output and welfare losses are also large and can be dramatically reduced by an aggressive subsidization of money market borrowing. The analysis offers some insights on the rationale for responding to a money markets freeze with full-allotment fixed-rate lending policies by central banks or the extension of government guarantees on non-deposit liabilities.
Keywords: Deposit Insurance; Financial Crisis; Money Markets; Spreads
JEL Codes: E44; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asymmetry between deposit-rich and deposit-poor banks (G21) | severe distortions in the allocation of credit during financial crises (F65) |
| increase in perceived bank failure risk (F65) | substantial reductions in money market volumes (E49) |
| increase in perceived bank failure risk (F65) | reallocation of capital across regions (R23) |
| aggressive subsidization of money market borrowing (E44) | reduction of output and welfare losses (D69) |
| full-allotment lending policies by central banks (E58) | improved credit allocation (E51) |
| government guarantees on non-deposit liabilities (H81) | mitigation of distortions in credit allocation (E51) |