Endogenous Financial Fragility and Prudential Regulation

Abstract:     
We study the fragility of the banking system and its implications for prudential regulation. In our framework, fragility stems from the interconnections banks establish to protect themselves from liquidity shocks. Like Allen and Gale (2000) we find mutual insurance of assets is privately advantageous. An assumption of Allen and Gale's analysis is that aggregate shocks are a zero probability event. This makes banks indifferent between arrangements leading to varying degrees of fragility should the zero probability event actually materialize.

We depart from Allen and Gale by assuming that the aggregate shock is no longer a zero probability event. As a result, banks find insurance by other banks valuable, but are no longer indifferent about the form the insurance takes. We build a framework examining the consequences for interbank insurance when individual bank fragility stems from a moral hazard problem, as in Calomiris Kahn (1991) or Diamond Rajan (1998).

We examine the implications of bank insurance choices for system fragility. In some conditions, banks prefer universal mutual insurance, and will opt for this arrangement. Depositors may also prefer universal mutual insurance as well, it may be socially suboptimal, since it places too high a correlation on individual bank failures. If banks also provide payments services, then the social costs may be much higher from having all fail than from having some failing, thus creating a justification for a regulatory intervention. We briefly examine possible modes of intervention.

Working Paper Series