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Essays On Banking
Diamond and Dybvig (1983) provide an analytical framework of modern banking: The key role of banks is to provide risk sharing between different types of consumers, and the mismatch of short-term liabilities and long-term asset can cause bank runs. In this dissertation, I use Diamond-Dybvig framework to analyze some key issues on banking: banks and the asset market, bank runs and bailouts, and characteristics of deposit contracts. The first chapter addresses the coexistence of banks and the asset market. Jacklin (1987) showed that banks are redundant if the asset market exists. I show that if there is aggregate liquidity shock, then asset prices will be volatile. This will make the arbitrage opportunities in the market risky. Sufficiently risk-averse depositors will not arbitrage. Hence, incentive-compatibility constraint is relaxed, leaving room for the bank to provide "insurance" to the depositors. The second chapter addresses the relationship between the probability of bank runs and bailouts. Following Keister (2010), my model includes both a private good and a public good. The major innovation in this paper is to determine the run probability by using the global-games approach in Goldstein and Pauzner (2005), making the run probability endogenous. I show that bailouts increase the ex-ante run probability through two channels. The first channel works through the misaligned objectives of the bank and the government: Runs are less costly for banks when there are bailouts. Hence, banks take on more risk than is socially optimal. The second channel works through the change in the depositor's incentives to run: Bailouts increase the probability that a depositor will get her money if she participates in a run, thus increasing the likelihood of a run. The third chapter characterizes how optimal deposit contract is related to the probability of bank runs. Peck and Shell (2003) show that the optimal deposit contract can tolerate bank runs if the run probability is low. In their two-consumer example, the deposit contract is a step function of the run probability. I generalize that example and show that, for some parameters which permit bank runs, the optimal contract changes continuously with the run probability until it reaches the threshold probability level. Above that threshold, the optimal contract eliminates bank runs. Hence, the run probability affects not only whether bank runs will be tolerated (like Peck and Shell's example) but also how bank runs will be tolerated.
Ph.D. of Economics
Doctor of Philosophy
dissertation or thesis