| Systemic risk is the risk that one bank's default or failure will lead to the default or failure of others. Chapter 1 analyzes systemic risk in a closed-economy setting, where the banks of different towns borrow and lend short-term funds that are financed by short-term deposits. Banks who borrow from other banks can commit moral hazard by secretly shifting funds into risky projects. Even though the standard demand and deposit contracts are incentive-compatible, they are incomplete since they do not take into account (privately-observed) incentive-distorting shocks which make the borrower more likely to default on the contracts. If the banks default, it is systemic; the banks' depositors and interbank creditors are then placed in competition for the control rights. We find that the optimal division rule (capital structure) will make the interbank claims on default proceeds subordinate to the depositor claims. The optimal deposit contracts are then 'demandable' and independent of bank capital. We also find that the ex post, most cost-efficient, policy of a banking authority that wishes to eliminate systemic default is a bailout of the borrowers. Chapter 2 applies a similar (complete contracts) banking model to an international, multi-good setting. The paper considers how systemic risk will cause lenders to ration bank credit in international capital markets. If the borrowing country's sovereign would like to finance a high-growth objective, she may attempt to assert some influence on the international market by guaranteeing the funds of foreign lenders or committing to bailout schemes. Such schemes only work when credible, however, and such credibility is unlikely under the high-growth objective. Extreme policies by the sovereign (such as confiscating lender proceeds) can touch off a crisis where the country is cut off from international capital markets altogether. In Chapter 3 we consider how incomplete contracts may be assisted by financial innovations. Using the Diamond and Dybvig (1983) model as an example, we study how financial innovations (such as time and savings deposits) can be used screen depositors and thereby reduce the costs to implementing the standard (incomplete) deposit contract. |