Abstract
This paper assesses the effects of the orderly liquidation of a failing bank and the ex post provision of deposit insurance on the prospect of bank runs. Assuming that the public institutions in charge of these policies lack commitment power, these interventions, both individually and jointly, are chosen and undertaken ex post. The costs of liquidation and redistribution across heterogeneous households play key roles in these decisions. If investment is sufficiently illiquid, a credible liquidation policy will deter runs. Despite the lack of commitment, deposit insurance, funded by an ex post tax scheme, will be provided unless it requires a (socially) undesirable redistribution of consumption that outweighs insurance gains. If taxes are set optimally ex post, runs are prevented by deposit insurance without costly liquidation. If not, a combination of the two policies will prevent runs.
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Notes
See Martin (2006) for a thorough presentation and discussion of deposit insurance with commitment.
This was brought out clearly in a presentation, http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm, by Ben Bernanke at Princeton University in September 2010.
Recent US legislation, the so-called Dodd–Frank Act, provides a process, termed an “Orderly Liquidation Authority” to deal with failed financial institutions outside of the FDIC system. In fact, this regulation was partly motivated by the need to make explicit the government’s role in the event of financial failures.
These costs of redistribution play a key role in the Cooper et al. (2008) study of bailout of one region by others in a fiscal federation.
This paper subsumes Cooper and Kempf (2011) which focused more narrowly on deposit insurance assuming a liquidation policy.
Our analysis of orderly liquidation is similar to the rescheduling of payments studied in this paper. However our environment differs from Ennis and Keister’s so as to generate different results, as will be clearer below.
We do not study this ex ante problem explicitly but rather focus on ex post redistribution following a bank run.
As in Chari and Kehoe (1990), the government is the only large player in the game.
As runs are not contemplated, there is no liquidation policy in place at the bank.
This is equivalent to the terminology in Ennis and Keister (2009) of banking fragility.
This issue does not arise in Ennis and Keister (2009) as their agents are homogenous except for tastes.
More formally, consider a direct revelation mechanism in which the regulator stipulates \(({\tilde{\chi }}^\mathrm{E}(\alpha ^0),{\tilde{\chi }}^\mathrm{L}(\alpha ^0))\). If a fraction \(\pi \) or less agents announce they are early types, they each obtain \({\tilde{\chi }}^\mathrm{E}(\alpha ^0)\). If more than a fraction \(\pi \) announce they are early types, then the allocation is random and agents obtain \({\tilde{\chi }}^\mathrm{E}(\alpha ^0)\) with a probability \(<\)1. The same rule applies for the allocation to late households: as long as a fraction \((1-\pi )\) or less announce they are late households they obtain \({\tilde{\chi }}^\mathrm{L}(\alpha ^0)\). Else, only a fraction of those announcing late get \({\tilde{\chi }}^\mathrm{L}(\alpha ^0)\). This creates feasible allocations for all feasible announcements. Clearly, as long as (10) holds, truthtelling is a Nash equilibrium. Under this allocation mechanism, late households have no incentive to misrepresent their types regardless of the announcement of other late households since obtaining \({\tilde{\chi }}^\mathrm{L}(\alpha ^0)\) by telling the truth is always feasible. In particular, there is no runs equilibrium in which late households pretend to be early households. Further, there are no other equilibria since early households will never pretend to be late households.
This is reminiscent of Villamil (1991) which separates the function of collecting deposits from the investment decision by separating the intermediary from an entrepreneur with whom it contracts and who has the power to liquidate. It is as if the bank’s capacity of liquidating was nil: \(\epsilon =0\). Importantly, Villamil (1991) assumes ex ante commitment by the entrepreneur to liquidation.
We are grateful to the referee for encouraging this comparison.
As in our analysis, there is no liquidation and no run if \(\epsilon =0\). But for Ennis and Keister (2009) there is a discontinuity since there is a run for \(\epsilon >0\).
With this restrictions on \({{\bar{\alpha }}}\), if the entire period 0 endowment is used to finance \(\chi ^{*\mathrm{E}}(\alpha ^0)\), the government has a sufficiently large tax base to fund DI.
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Russell Cooper is grateful to the NSF for financial support. Comments from Todd Keister, Antoine Martin, Jonathan Willis and seminar participants at the Banque de France, the University of Bologna, the Central Bank of Turkey, Koc University, the RMM Conference 2010 at the University of Toronto, Washington University at St. Louis, the Riksbank, the University of Pennsylvania, Rice University, the University of Iowa, the Tinbergen Institute and the Federal Reserve Bank of Kansas City are appreciated. We are grateful to the editor and referee for valuable suggestions.
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Cooper, R., Kempf, H. Deposit insurance and bank liquidation without commitment: Can we sleep well?. Econ Theory 61, 365–392 (2016). https://doi.org/10.1007/s00199-015-0897-4
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DOI: https://doi.org/10.1007/s00199-015-0897-4