Interbank insurance, Liquidity shocks, Banks runs
The goal of this paper is to investigate the possibility of incorporating interbank insurance among commercial banks. This is done by building upon the Diamond-Dybvig model. We extend the Diamond-Dybvig model in three ways. First we abandon the single intermediary environment by introducing a banking sector that is made up of a continuum of banks of mass 1; we assume that a small proportion (exogenously given) of banks experience runs. Next, we suppose that all banks have access to and invest in interbank insurance. Lastly, it is assumed that when banks withdraw illiquid funds prematurely they must pay a mandatory transaction cost. In a banking system with liquidity shocks we show that, by designing an optimal interbank insurance contract, the possibility of a bank becoming illiquid during a bank run is zero.
Dr. Nurlan Turdaliev
Dr. Yahong Zhang
Master of Arts
Major Research Paper