Liquidity Coinsurance, Moral Hazard, and Financial Contagion

We study the propagation of financial crises among regions in which banks are protected by limited liability and may take excessive risk. The regions are affected by negatively correlated liquidity shocks, so liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks...

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Bibliographic Details
Published in:The Journal of finance (New York) 2007-10, Vol.62 (5), p.2275-2302
Main Authors: BRUSCO, SANDRO, CASTIGLIONESI, FABIO
Format: Article
Language:English
Subjects:
Bank assets
Bank capital
Bank liquidity
Banks
Capital investments
Coinsurance
Economic crisis
Economic shock
Financial crisis
Financial economics
Financial investments
Financial models
Financial research
Investors
Liquidity
Long term investments
Moral hazard
Pareto optimum
Risk
Securities markets
Spillovers
Studies
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Summary:We study the propagation of financial crises among regions in which banks are protected by limited liability and may take excessive risk. The regions are affected by negatively correlated liquidity shocks, so liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky a limited amount of capital is sufficient to prevent risk-taking, but when financial markets are open capital becomes insufficient. Thus, bankruptcy occurs with positive probability and the crisis spreads to other regions via financial linkages. Opening financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk-taking.
ISSN:0022-1082
1540-6261
DOI:10.1111/j.1540-6261.2007.01275.x