A Theory of Bank Illiquidity and Default with Hidden Trades

Panetti, Ettore

doi:10.2139/ssrn.2052874

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A Theory of Bank Illiquidity and Default with Hidden Trades

Review of Finance, 21(3):1123– 1157, May 2017.

60 Pages Posted: 7 May 2012 Last revised: 8 Apr 2020

See all articles by Ettore Panetti

Ettore Panetti

- Centre for Studies in Economics and Finance (CSEF); UECE - Research Unit on Complexity in Economics; SUERF - The European money and finance forum

Date Written: September 7, 2016

Abstract

How does the availability of alternative investment opportunities for banks' depositors affect the reaction of the banking system to aggregate liquidity shocks? And what are the implications, if any, for banking regulation? To answer these questions, I study a Diamond-Dybvig environment, where banks hedge against aggregate liquidity risk in the interbank market or default, and depositors borrow and lend in a hidden-bond market. In this framework, banks offer an endogenously incomplete contract, and default in equilibrium only when facing systemic liquidity risk. In this case, the allocation at default is inefficient, and countercyclical liquidity requirements are welfare-improving.

Keywords: financial intermediation, liquidity, hidden trades, insurance, regulation

JEL Classification: E44, G21, G28

Suggested Citation: Suggested Citation

Panetti, Ettore, A Theory of Bank Illiquidity and Default with Hidden Trades (September 7, 2016). Review of Finance, 21(3):1123– 1157, May 2017., Available at SSRN: https://ssrn.com/abstract=2052874 or http://dx.doi.org/10.2139/ssrn.2052874