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Report
Expectations versus fundamentals: does the cause of banking panics matter for prudential policy?
There is a longstanding debate about whether banking panics and other financial crises always have fundamental causes or are sometimes the result of self-fulfilling beliefs. Disagreement on this point would seem to present a serious obstacle to designing policies that promote financial stability. However, we show that the appropriate choice of policy is invariant to the underlying cause of banking panics in some situations. In our model, the anticipation of being bailed out in the event of a crisis distorts the incentives of financial institutions and their investors. Two policies that aim to ...
Working Paper
Aggregate demand management with multiple equilibria
We study optimal government policy in an economy where (i) search frictions create a coordination problem and generate multiple Pareto-ranked equilibria and (ii). The government finances the provision of a public good by taxing trade. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will affect the equilibrium selection process. We show that when the equilibrium selection rule is based on the concept of risk dominance, higher tax rates make coordination on the Pareto-superior ...
Working Paper
Optimal Banking Contracts and Financial Fragility
We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the constrained efficient allocation of resources in closed form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation resembles a standard bank deposit in that it has a demand able debt-like structure. When withdrawals are unusually high, however,depositors who withdraw relatively late experience significant losses. This contractual ...
Working Paper
Bank runs and institutions : the perils of intervention
Governments typically respond to a run on the banking system by temporarily freezing deposits and by rescheduling payments to depositors. Depositors may even be required to demonstrate an urgent need for funds before being allowed to withdraw. We study ex post efficient policy responses to a bank run and the ex ante incentives these responses create. Given that a run is underway, the efficient response is typically not to freeze all remaining deposits, since this would impose heavy costs on individuals with urgent withdrawal needs. Instead, (benevolent) government institutions would allow ...
Report
Floor systems and the Friedman rule: the fiscal arithmetic of open market operations
In a floor system of monetary policy implementation, the central bank remunerates bank reserves at or near the market rate of interest. Some observers have expressed concern that operating such a system will have adverse fiscal consequences for the public sector and may even require the government to subsidize the central bank. We show that this is not the case. Using the monetary general equilibrium model of Berentsen et al. (2014), we show how a central bank that supplies reserves through open market operations can always generate non-negative net income, even when using a floor system to ...
Report
Why are banks holding so many excess reserves?
The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve's liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve's policy initiatives and in no way ...
Report
Run equilibria in a model of financial intermediation
We study the Green and Lin (2003) model of financial intermediation with two new features: traders may face a cost of contacting the intermediary, and consumption needs may be correlated across traders. We show that each feature is capable of generating an equilibrium in which some (but not all) traders ?run? on the intermediary by withdrawing their funds at the first opportunity regardless of their true consumption needs. Our results also provide some insight into elements of the economic environment that are necessary for a run equilibrium to exist in general models of financial ...
Journal Article
Stability of funding models: an analytical framework
With the recent financial crisis, many financial intermediaries experienced strains created by declining asset values and a loss of funding sources. In reviewing these stress events, one notices that some arrangements appear to have been more stable?that is, better able to withstand shocks to their asset values and/or funding sources?than others. Because the precise determinants of this stability are not well understood, gaining a better grasp of them is a critical task for market participants and policymakers as they try to design more resilient arrangements and improve financial regulation. ...
Journal Article
Dollarization as a monetary arrangement for emerging market economies
Official dollarization refers to the adoption of the U.S. dollar as legal tender in place of the national currency. Some Latin American countries have recently dollarized, and others have seriously considered dollarization. This article discusses the reasons behind the surge of interest in dollarization and provides a review of the new academic literature on the topic. It discusses in detail some of the factors that are commonly considered to be the important costs and benefits of dollarizing. The paper also provides an analysis of the existing liability dollarization in several countries and ...
Journal Article
Understanding monetary policy implementation
The Federal Reserve implements its monetary policy objectives by intervening in the interbank market for overnight loans. In particular, it aims to change the supply of reserves available to commercial banks so that the (average) interest rate in this market equals an announced target rate. A recent change in legislation will give the Federal Reserve greater flexibility in this process by allowing it to pay interest on reserve balances. Together, the change and recent events in financial markets have renewed interest in the process of monetary policy implementation. This article presents a ...