This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

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Bank Runs, Deposit Insurance, and Liquidity

We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality¶, and (v) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

Market liquidity and funding liquidity

We provide a model that links a security’s market liquidity — i.e., the ease of trading it — and traders’ funding liquidity — i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences “flight to liquidity” events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

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Market Liquidity and Funding Liquidity

Over the last thirty years, a new paradigm in banking theory has overturned economists' traditional vision of the banking sector. The asymmetric information model, extremely powerful in many areas of economic theory, has proven useful in banking theory both for explaining the role of banks in the economy and for pointing out structural weaknesses in the banking sector that may justify government intervention. In the past, banking courses in most doctoral programs in economics, business, or finance focused either on management or monetary issues and their macroeconomic consequences; a microeconomic theory of banking did not exist because the Arrow-Debreu general equilibrium model of complete contingent markets (the standard reference at the time) was unable to explain the role of banks in the economy. This text provides students with a guide to the microeconomic theory of banking that has emerged since then, examining the main issues and offering the necessary tools for understanding how they have been modeled. This second edition covers the recent dramatic developments in academic research on the microeconomics of banking, with a focus on four important topics: the theory of two-sided markets and its implications for the payment card industry; "non-price competition" and its effect on the competition-stability tradeoff and the entry of new banks; the transmission of monetary policy and the effect on the functioning of the credit market of capital requirements for banks; and the theoretical foundations of banking regulation, which have been clarified, although recent developments in risk modeling have not yet led to a significant parallel development of economic modeling. Praise for the first edition:"The book is a major contribution to the literature on the theory of bankingand intermediation. It brings together and synthesizes a broad range ofmaterial in an accessible way. I recommend it to all serious scholars andstudents of the subject. The authors are to be congratulated on a superbachievement." -- Franklin Allen, Nippon Life Professor of Finance and Economics, WhartonSchool, University of Pennsylvania "This book provides the first comprehensive treatment of the microeconomicsof banking. It gives an impressive synthesis of an enormous body ofresearch developed over the last twenty years. It is clearly written and apleasure to read. What I found particularly useful is the great effort thatXavier Freixas and Jean-Charles Rochet have taken to systematicallyintegrate the theory of financial intermediation into classicalmicroeconomics and finance theory. This book is likely to become essentialreading for all graduate students in economics, business, and finance." -- Patrick Bolton, Barbara and David Zalaznick Professor of Business, Columbia University Graduate School of Business "The authors have provided an extremely thorough and up-to-date survey ofmicroeconomic theories of financial intermediation. This work manages to beboth rigorous and pleasant to read. Such a book was long overdue and shouldbe required reading for anybody interested in the economics of banking andfinance." -- Mathias Dewatripont, Professor of Economics, ECARES, Universit

Microeconomics of banking

Loans are illiquid when a lender needs relationship‐specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.

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Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking

A model is presented in which demand deposits backed by fractional currency reserves and public insurance can be beneficial. The model uses Samuelson's pure consumption-loans model. The case for demand deposits, reserves, and deposit insurance rests on costs of illiquidity and incomplete information. The effect of deposit insurance depends upon how, and at what cost, the government meets its insurer's obligation — something which is not specified in practice. It remains possible that demand deposits and deposit insurance are a distortion, and reserve requirements serve only to limit the size of this distortion.

John B. Bryant

Papers

A Model of Reserves, Bank Runs, and Deposit Insurance