Banks as potentially crooked secret-keepers…

Mostly Economics

Timothy Jackson and Laurence J. Kotlikoff in this paper:

Bank failures are generally liquidity as well as solvency events. Whether it is households running on banks or banks running on banks, defunding episodes are full of drama. This theater has, arguably, lured economists into placing liquidity at the epicenter of financial collapse. But loss of liquidity describes how banks fail. Bad news about banks explains why they fail. This paper models banking crises as triggered by news that the degree (share) of banking malfeasance is likely to be particularly high.

The malfeasance share follows a state-dependent Markov process. When this period’s share is high, agents rationally raise their probability that next period’s share will be high as well. Whether or not this proves true, agents invest less in banks, reducing intermediation and output.

Deposit insurance prevents such defunding and stabilizes the economy. But it sustains bad banking, lowering welfare.

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This entry was posted in applied price theory on by .

About Jim Rose

Utopia - you are standing in it promotes a classical liberal view of the world and champion the mass flourishing of humanity through capitalism and the rule of law. The origin of the blog is explained in the first blog post at https://utopiayouarestandinginit.wordpress.com/2014/03/12/why-call-my-blog-utopia-you-are-standing-in-it/

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