Optimal financial crises: A note on Allen and Gale

This note provides an example of an optimal banking panic. We construct a model in which a banking panic is triggered by the banker, not the depositors. When the banker receives a pessimistic information on the return on the bank’s assets, he liquidates them prematurely in order to protect his capital. In the face of this liquidation, all depositors withdraw their funds prematurely. The premature liquidation of the bank’s assets strengthens the bank’s balance sheet. As a result, the banking panic does not cause bank failure and the government should not try to prevent the panic. Such a panic occured in 1857 in the United States. JEL Classification G21     

Adverse selection and moral hazard: Quantitative implications for unemployment insurance

A model of optimal unemployment insurance with adverse selection and moral hazard is constructed. The model generates both qualitative and quantitative implications for the optimal provision of unemployment insurance. Qualitatively, for some agents, incentives in the optimal contract imply consumption increases over the duration of non-employment. Calibrating the model to a stylized version of the U.S. economy quantitatively illustrates these theoretical predictions. The optimal contract achieves a welfare gain of 1.94% relative to the current U.S. system, an additional 0.87% of gains relative to a planner who ignores adverse selection and focuses only on moral hazard.     

Premium setting and bank behavior in a voluntary deposit insurance scheme

This study analyzes the effect of premium rates on banks’ incentives to join a deposit insurance scheme and their incentives to invest in risky projects under a voluntary deposit insurance scheme. We find that in order to maximize social welfare, the insurance agency must either set the premium rate to be low so as to attract all banks to join the insurance scheme, or not to have the deposit insurance at all. However, the low premium rate in the voluntary scheme does not balance the budget of the deposit insurance. We also show that in the compulsory deposit insurance scheme, however, it is possible to impose an optimal premium rate that can balance the insurance agency’s budget and achieve the highest social welfare. The results also present the dominance of the compulsory scheme over the voluntary scheme in terms of maximizing social welfare and balancing the budget.