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Working Paper
Limited enforcement and efficient interbank arrangements
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 ...