Contingent Contracts in Banking: Insurance or Risk Magnification?

50 Pages Posted: 15 Mar 2021

See all articles by Hans Gersbach

Hans Gersbach

ETH Zurich - CER-ETH -Center of Economic Research; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

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Date Written: March 2021

Abstract

What happens when banks compete with deposit and loan contracts contingent on macroeconomic shocks? We show that the private sector insures the banking system efficiently against banking crises through such contracts when banks focus on expected profit maximization and failing banks go bankrupt. When risks are large, banks may shift part of the risk to depositors who receive state-contingent contracts. Repackaging of the risk among depositors can improve welfare. In contrast, when failing banks are rescued, new phenomena such as risk creation or magnification emerge, which would not occur with non-contingent contracts. In particular, depositors receive non-contingent contracts with comparatively high interest rates, while entrepreneurs obtain loan contracts that demand high repayment in good times and low repayment in bad times. As a result, banks overinvest and generate large macroeconomic risks, even if the underlying productivity risk is small or zero.

JEL Classification: D41, E4, G2

Suggested Citation

Gersbach, Hans, Contingent Contracts in Banking: Insurance or Risk Magnification? (March 2021). CEPR Discussion Paper No. DP15884, Available at SSRN: https://ssrn.com/abstract=3805299

Hans Gersbach (Contact Author)

ETH Zurich - CER-ETH -Center of Economic Research ( email )

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CESifo (Center for Economic Studies and Ifo Institute)

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