DP4735 Financial Intermediation with Contingent Contracts and Macroeconomic Risks

Author(s): Hans Gersbach

Publication Date: November 2004

Keyword(s): financial intermediation , macroeconomic risks , state contingent contracts , banking regulation

JEL(s): D41 , E40 , G20

Programme Areas: Financial Economics , Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP4735.asp

We examine financial intermediation when banks can offer deposit or loan contracts contingent on macroeconomic shocks. We show that the risk allocation is efficient provided there is no workout of banking crises. In this case, banks will shift part of the risk to depositors. In contrast, under a workout of banking crises, depositors receive non-contingent contracts with high interest rates while entrepreneurs obtain loan contracts that demand a high repayment in good times and little in bad times. As a result, the present generation overinvests and banks create large macroeconomic risks for future generations, even if the underlying risk is small or zero.