The Effect of Safe Assets on Financial Fragility in a Bank-Run Model
Abstract: Risk-averse investors induce competitive intermediaries to hold safe assets, thereby lowering the probability of a run and reducing financial fragility. We revisit Goldstein and Pauzner (2005), who obtain a unique equilibrium in the banking model of Diamond and Dybvig (1983) by introducing risky investment and noisy private signals. We show that, in the optimal demand-deposit contract subject to sequential service, banks hold safe assets to insure investors against investment risk. Consequently, fewer investors withdraw prematurely, which reduces the probability of a bank run. Safe asset holdings increase investor welfare and may increase the bank?s provision of liquidity.
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Description: Full text
Provider: Federal Reserve Bank of Cleveland
Part of Series: Working Papers (Old Series)
Publication Date: 2014-12-22
Pages: 51 pages