Banks as Potentially Crooked Secret Keepers

Bank failures are generally liquidity as well as solvency events. Whether it is households running on banks or banks running on banks, defunding episodes are full of drama. This theater has, arguably, lured economists into placing liquidity at the epicenter of financial collapse and liquidity provision as opposed to improved intermediation as the rationale for banks. But loss of liquidity describes how banks fail . Bad news about banks explains why they fail. This paper models banks as arising from asymmetric information. Banks have superior knowledge of investment opportunities. But bankers, or at least a subset, also know how to steal. Hence, we model banking crises as triggered by news that the degree (share) of banking malfeasance is likely to be particularly high. The malfeasance share follows a Markov process. When this period's share is high, agents rationally raise their probability that next period's share will be high as well. Whether or not this proves true, agents invest less in banks, reducing intermediation and output. Worse, bad bankers can infect good bankers. When bad bankers are thought to abound, good bankers have less incentive to secure a high return on their investment. Deposit insurance prevents defunding runs and stabilizes the economy. But it sustains bad banking, lowering welfare. Private monitoring helps, but is no panacea. It partially limits banking malfeasance. But it does so inefficiently as households needlessly replicate each other's costly information acquisition. Moreover, if private audits become public, private monitoring breaks down due to free-riding. Redistribution between generations that do and do not confront the highest share of banking malfeasance does not relieve the problem. What does improve matters is government real-time disclosure of banking malfeasance. This mitigates, if not eliminates, the asymmetric information problem leading to potentially large gains in both nonstolen output and welfare.

Automated summary

Bank failures are usually caused by liquidity and solvency events, with the degree of malfeasance within banks triggering crises. Deposit insurance can prevent funding runs but also sustains bad banking practices, while real-time government disclosure of malfeasance can lead to significant gains in non-stolen output and welfare by eliminating asymmetric information problems.