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The Economics of Contingent Re-Auctions



swp0000.dvi Liquidity Coinsurance, Moral Hazard and Financial Contagion∗ Sandro Brusco§ Fabio Castiglionesi¶ July 2005. Abstract We study the propagation of financial crises between regions characterized by moral hazard problems. The source of the problem is that banks are protected by limited liability and may engage in excessive risk taking. The regions are affected by negatively correlated liquidity shocks, so that liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently cap- italized. Under autarky, a limited investment is needed to achieve optimality, so that a limited amount of capital is sufficient to prevent risk-taking. With interbank deposits the optimal investment increases, and capital becomes insufficient to pre- vent excessive risk-taking. Thus bankruptcy occurs with positive probability and the crises spread to other regions via the financial linkages. Opening the financial markets is nevertheless Pareto improving; consumers benefit from liquidity coin- surance, although they pay the cost of excessive risk-taking. Finally, we show that in this framework a completely connected deposit structure is more conducive to financial crises than an incompletely connected structure. JEL Classification: G21. Keywords: Moral Hazard, Liquidity Coinsurance, Contagion. ∗We would like to thank Michele Boldrin, Giovanni Cespa, Ignacio Peña, Mar- garita Samartín, Georges Siotis, Branko Urosevic and seminar participants at Univer- sitat Autònoma de Barcelona, XII Foro de Finanzas, Universidad Carlos III and the CFS Conference at Goethe University Frankfurt for useful comments. The usual disclaimer applies. §Department of Economics, State University of New York at Stony Brook and De- partamento de Economía de la Empresa, Universidad Carlos III de Madrid. E-mail: [email protected] ¶Departament d’ Economia, Universitat Autònoma de Barcelona. E-mail: [email protected] 1 1 Introduction It is sometimes claimed

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