Liquidity Provision vs. Deposit Insurance: Preventing Bank Panics Without Moral Hazard

FRB of Kansas City Research Working Paper No. 01-05

32 Pages Posted: 17 Dec 2001

See all articles by Antoine Martin

Antoine Martin

Federal Reserve Bank of New York - Research and Statistics

Date Written: August 2001

Abstract

In this paper I ask whether a central bank policy of providing liquidity to banks during panics can prevent bank runs without causing moral hazard. This kind of policy has been widely advocated, most notably by Bagehot (1873). To analyze such a policy, I build a model with three key features: 1) bank panics can occur in equilibrium, 2) there can be moral hazard, 3) the central bank can create money which is willingly held. I show that a particular central bank repurchase policy provides liquidity to the banking system and can prevent bank panics without moral hazard problems. I also show that a deposit insurance policy, while preventing runs, creates moral hazard problems.

Keywords: Banking Panics, Liquidity Provision, Deposit Insurance

JEL Classification: E5, G2

Suggested Citation

Martin, Antoine, Liquidity Provision vs. Deposit Insurance: Preventing Bank Panics Without Moral Hazard (August 2001). FRB of Kansas City Research Working Paper No. 01-05, Available at SSRN: https://ssrn.com/abstract=293829 or http://dx.doi.org/10.2139/ssrn.293829

Antoine Martin (Contact Author)

Federal Reserve Bank of New York - Research and Statistics ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-6943 (Phone)