Chao Gu, Cyril Monnet, Ed Nosal, and Randall Wright
Working Paper 2023-2
February 2023
Abstract:
Are financial intermediaries—in particular, banks—inherently unstable or fragile, and if so, why? We address this question theoretically by analyzing whether model economies with financial intermediation are more prone than those without it to multiple, cyclic, or stochastic equilibria. We consider several formalizations: insurance-based banking, models with reputational considerations, those with fixed costs and delegated investment, and those where bank liabilities serve as payment instruments. Importantly for the issue at hand, in each case banking arrangements arise endogenously. While the economics and mathematics differ across specifications, they all predict that financial intermediation engenders instability in a precise sense.
JEL classification: D02, E02, E44, G21
Key words: banking, financial intermediation, instability, volatility
https://doi.org/10.29338/wp2023-02
The authors thank George Selgin, Steve Williamson, David Andolfatto, Allen Head, Alberto Teguia, Yu Zhu, and William Diamond for their input. Wright acknowledges support from the Ray Zemon Chair in Liquid Assets and the Ken Burdett Chair in Search Theory and Applications at the Wisconsin School of Business. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Chao Gu is with the University of Missouri. Cyril Monnet is with the University of Berne and Study Center Gersenzee. Randall Wright is with Zhejiang University and the University of Wisconsin-Madison. Please address questions regarding content to Ed Nosal, Federal Reserve Bank of Atlanta.
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