Banks, Liquidity and Economic Growth Comments on : Gaytán and Ranciere Banks, Liquidity and Economic Growth March 17, 2006 Fabio Braggion Tilburg University and CentER

The Question How Banking System and Financial Fragility evolves with GDP growth? Rational Behavior of Economic Agents determine the structure of the Banking System For certain levels of GDP agents may prefer to have a fragile banking system

Model Based on Diamond and Dybvig (1981) and Cooper and Ross (1998) Two periods overlapping generation model Young Work - Old make investment decisions and consume Agents are subject to liquidity shocks. Early types and late type. Types are private information Two technologies: –liquid technology –Illiquid technology (production) Like in Diamond and Dybvig… two equilibria –Bank run and no-bank run

Bank can design contract –Allow bank run –Give insurance: induce late types to tell the truth What contract is best? It depends on the stage of development

Preferred Result For intermediate probability of a bank run and high enough risk aversion: –Low Income Countries prefer insurance against bank runs –Middle income countries prefer to exposed to run –High Income Countries prefer insurance against bank runs

Intuition Trade off: take the gamble or be insured Agents are risk averse: they don’t like gambling They try to get partially insured by accumulating more liquid assets

Intuition Trade off: take the gamble or be insured Insurance has a cost: late types must tell the truth. An IC constraint is binding and distorting the economy

Intuition Low income. The economy is poor. The accumulation of liquid assets imposes a big loss on late types. Enforce the IC Middle income: The economy is richer, and the loss for late types smaller. Expose the systems to runs High income: (IC) distortion decreases with income. Insurance gives a result close to first best

Does it really apply? The result is sensitive to the parameters values What does it mean to have intermediate probability? And also curvature of the utility function Possibility to get a number: Sapienza, Guiso and Zingales (2005)

Check out Also young agents are risk averse Decisions of old agents determine their endowment at the beginning of their second period For high enough risk aversion there is the possibility of an intergenerational transfer (young promising a payment to the old) that induces the old to choose insurance

Towards a Theory of Total Factor Productivity By accumulating liquidity banks make the existing stock of capital more efficient Banks avoid inefficient liquidation of physical capital On the empirical side: Benhabib and Spiegel, 2000

Use the set up of this model To explain TFP declines associated to Financial Crises (Meza and Quintin, 2005) Notable application: The great depression In the spirit of Bernanke, 1983

Growing through phases Both with covered and uncovered banking system growth is driven by: –Capital accumulation for low levels of wealth –Total factor productivity growth for intermediate-low level of wealth –Capital accumulation (again) for higher level of wealth

Parallel with Matsuyama “Growing through Cycles” 1999 But different channel: while wealth increases, the financial system becomes more efficient and copes better with liquidity shocks

A dynamic model of institutions? The optimal contract evolves with the state variable Novel features If you call the contract “institution”, we may have a dynamic model of institutions