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Run-Prone Banking and Asset Markets

41 Pages Posted: 21 Dec 2007  

Marie Hoerova

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Date Written: December 2007

Abstract

I analyze the role that asset markets play in the performance and stability of the run-prone banking sector. Banks insure consumers against privately observed liquidity shocks. Asset market investments insure consumers against losses from bank runs. If the probability of a run is small, then banks specialize fully into the provision of liquidity insurance: They provide a higher degree of liquidity insurance when compared to the economy with banks alone. If the probability of a run is high, consumers prefer to invest solely through the asset market. Insurance against runs provided by the market investment reduces consumers' incentives to run. Increased provision of liquidity insurance by banks has the opposite effect. I derive conditions under which the latter effect dominates and the probability of a run is higher than with banks alone.

Keywords: Bank runs, Asset markets, Liquidity, Financial stability, Mechanism design

JEL Classification: E44, G21

Suggested Citation

Hoerova, Marie, Run-Prone Banking and Asset Markets (December 2007). ECB Working Paper No. 845. Available at SSRN: https://ssrn.com/abstract=1054981

Marie Hoerova (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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