Intertemporal diversification in financial intermediation

This paper examines the incentive problem between a bank and depositors (or deposit insurer): limited liability makes risk-shifting lucrative. We show how intertemporal diversification of lending decisions – i.e. bank’s loan portfolio consists of overlapping long-term loans and is thus gradually renewed – may solve the incentive problem of risk-shifting. A new (or expanding) bank sets a high-equity level and acquires depositors’ confidence. Subsequently, it can allow its equity to depreciate to a permanently lower level. Depositors can control the bank by monitoring equity and realized credit losses ex post; they do not have to monitor bank’s lending choices ex ante. Maturity mismatch – illiquidity of long-term loans and liquidity of deposits – is optimal. The analysis can be extended more generally to the borrower–lender relationship.