Limited enforcement and efficient interbank arrangements
Abstract: Banks have historically provided mutual insurance against asset risk, where the insurance arrangement itself was characterized by limited enforcement. This paper shows that a non-trivial interaction between asset and liquidity risk plays a crucial role in shaping optimal banking arrangements in the presence of limited enforcement. We find that liquidity shocks are essential for the provision of insurance against asset shocks, as they mitigate interbank enforcement problems. These enforcement problems generate endogenous aggregate uncertainty as investment allocations depend upon the joint distribution of shocks. Paradoxically, a negative correlation between liquidity and asset shocks ameliorates enforcement limitations and facilitates interbank cooperation.
File(s): File format is application/pdf http://www.minneapolisfed.org/research/common/pub_detail.cfm?pb_autonum_id=835
Provider: Federal Reserve Bank of Minneapolis
Part of Series: Working Papers
Publication Date: 2001