This paper introduces risk-averse preferences in Chari and Jagannathan (1988). A first motivation for this extension is to give a positive role for afinancial intermediary in the economy, who offers risk-sharing contracts toliquidity seeking individuals. In this framework, both informationinduced anpure panic runs will occur. The second motivation is to complete Chari and Jagannathan's welfare analysis by comparing suspension of convertibility and deposit insurance, given their relative benefits and costs (of randomizationin meeting liquidity needs or deadweight taxation). It is shown that the choice between the two contracts depends on the level of risk aversion, the intertemporal discount factor and the attributes about the underlying technology.

We survey the theories on why banks promise to pay par on demand and examine evidence on the conditions under which banks have promised to pay the par value of deposits and banknotes on demand when holding only fractional reserves. The theoretical literature is divided into four strands: liquidity provision; asymmetric information; legal restrictions; and a medium of exchange. We assume that it is not zero cost to make a promise to redeem a liability at par value on demand. If so, then the conditions in the theories that result in par redemption are possible explanations why banks promise to pay par on demand. If the explanation based on customers’ demand for liquidity is correct, payment of deposits at par will be promised when banks hold assets that are illiquid in the short run. If the asymmetric-information explanation based on the difficulty of valuing assets is correct, the marketability of banks’ assets determines whether banks promise to pay par. If the legal restrictions explanation of par redemption is correct, banks will not promise to pay par if they are not required to do so. If the transaction explanation is correct, banks will promise to pay par if the deposits are used in transactions. We examine the history of banking in several countries in different eras: fourth century Athens, medieval Italy, Tokugawa Japan, and free banking and money market mutual funds in the United States. Each of the theories explains some of the observed banking arrangements and none explains all of them.

This paper incorporates costly voluntary acquisition of information à la Nikitin and Smith (2007) [Nikitin, M., Smith, R.T., 2007. Information acquisition, coordination, and fundamentals in a financial crisis. Journal of Banking and Finance, in press, doi:10.1016/j.jbankfin.2007.04.031], in a framework similar to Allen and Gale (2000) [Allen, F., Gale, D., 2000. Financial contagion. Journal of Political Economy 108, 1–33], without relying on any unexpected shock to model contagion. In this framework, contagion and financial crises are the result of information gathering by depositors, weak fundamentals and an incomplete market structure of banks. It also shows how financial systems entering a recession can affect others with apparently stronger economic conditions (contagion). Finally, this is the first paper to investigate the effectiveness of the Contingent Credit Line procedures, introduced by the IMF at the end of the nineties, as a mechanism to prevent the propagation of crises.

This paper studies the interaction between bank capital regulation, moral hazard and co-existence of traditional and shadow banks. Bank managers can choose between traditional banking and off-balance sheet special purpose vehicles (SPV), in a setup with deposit insurance and moral hazard. We first show that in the absence of SPV intermediation, capital requirements are ineffective at preventing the moral hazard problem originated by deposit insurance. We find that shadow banks can improve financial stability, when there is full information sharing. Finally, we analyze the case of neglected tail risk. We find that under such circumstances, the SPV will increase financial risk by exposing the system to extreme events.

Intervention has taken different forms in different countries and periods of time. Moreover, recent episodes showed that in front of an imminent crisis, the promise of no interventions made by governments is barely credible. In this paper we address the problem of resolving banking crises from the government perspective, taking into account the fact that preventing banking crises is crucial for the government. In addition, we introduce the moral hazard problem, inherent in the banking system, and consider the interaction between regulation, policy measures and banks’ behavior. To the best of our knowledge, this is the first paper that compares different policy plans to resolve banking crises in an environment where insufficiently capitalized banks have incentives to take risk, and the government has to decide whether to provide public services or impede crises. We show that when individuals highly value public services then the best policy in terms of welfare is to apply the tax on early withdrawals, as the government can transfer those taxes to the whole population by investing in public services (although at some cost). Conversely, when individuals assign a low value to consuming public services, recapitalization is the dominant policy. Finally, when the probability of a crisis is sufficiently high, capital requirements should be used.

This paper analyzes market discipline in a many-bank economy where contagion and bank runs interact. We present a model with differently-informed depositors, where those depositors that are more informed have incentives to monitor banks’ investments. It is shown that when banks are undercapitalized, and the probability of success of the risky asset is low, depositors might prefer a contract that is subject to bank runs in the interim period to a contract that allows banks to gamble with their funds and maintain their investment.The results of the paper emphasize the benefits of private monitoring of banks in order to promote market discipline.

This study examines the interaction between bank deposit market competition, incentives to take risks on the asset side, and willingness to participate in the interbank market for liquidity coinsurance. The interbank market in the model has two countervailing effects on risk-taking. First, it allows for more profitable long-term investment, which adds to a bank’s charter value and decreases risk-taking motives. Second, greater investment in the long-term asset also makes risk-taking potentially more profitable, thus eroding charter value. Finally, risk-taking motives also influence banks’ decisions to participate in the interbank market. We demonstrate how a combination of capital requirements and posting a surety bond can restore charter value, promote cooperation and boost economic activity. Additionally, this measure does not limit competition in generating charter value and implies lower costs than capital requirements alone.

We examine a policy in which owners of banks provide funds in the form of a surety bond in addition to equity capital. This policy would require banks to provide the regulator with funds that could be invested in marketable securities. Investors in the bank receive the income from the surety bond as long as the bank is in business. The capital value could be used by bank regulators to pay off the banks’ liabilities in case of bank failure. After paying depositors, investors would receive the remaining funds, if any. Analytically, this instrument is a way of creating charter value but, as opposed to Keeley (1990) and Hellman, Murdock and Stiglitz (2000), restrictions on competition are not necessary to generate positive rents. We demonstrate that capital requirements alone cannot prevent the moral hazard problem arising from deposit insurance.