THE INVISIBLE HAND AND THE BANKING TRADE: SEIGNIORAGE, RISK-SHIFTING, AND MORE

ABSTRACT:The classic Diamond-Dybvig model of banking assumes perfect competition and abstracts from issues ofmoral hazard. To reflect conditions prevailing in UK banking, however, we incorporate market powerand risk-taking by banks with limited liability, with explicit analytical results for the case wheredepositors are highly risk averse. We show how the effectiveness of bank franchise value in checkingrisk-taking may be undermined by the prospect of bailouts; and how bail-in provisions are beingdesigned to correct this.