Unobservable Savings, Risk Sharing and Default in the Financial System (Panetti E.)

Basel I-III Information Asymmetry and Transparency Regulation Stability&Soundness

Abstract In the present paper, I analyze how unobservable savings affect risk sharing and bankruptcy decisions in the financial system. I extend the Diamond and Dybvig (1983) model of financial intermediation to an environment with heterogeneous intermediaries, aggregate uncertainty and agents' hidden borrowing and lending. I demonstrate three results. First, unobservability imposes a burden on financial intermediaries, that in equilibrium are not able to offer a banking contract that balances insurance and incentive motivations. Second, unobservable markets do induce default, but only as long as insurance markets are incomplete. Therefore, their presence is not a rationale for government intervention on bankruptcy via "resolution regimes". Third, even in case of complete markets the competitive equilibrium is inefficient, and a simple tier-1 capital ratio similar to the one proposed in the Basel III Accord implements the efficient allocation.
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Libref/ Panetti E. (2011) "Unobservable Savings, Risk Sharing and Default in the Financial System", MRPA Working Paper No. 29542, pp. 1 - 38
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