DP15884 Contingent Contracts in Banking: Insurance or Risk Magnification?
What happens when banks compete with deposit and loan contracts contingent on macroeconomic shocks? We show that the private sector insures the banking system efficiently against banking crises through such contracts when banks focus on expected profit maximization and failing banks go bankrupt. When risks are large, banks may shift part of the risk to depositors who receive state-contingent contracts. Repackaging of the risk among depositors can improve welfare. In contrast, when failing banks are rescued, new phenomena such as risk creation or magnification emerge, which would not occur with non-contingent contracts. In particular, depositors receive non-contingent contracts with comparatively high interest rates, while entrepreneurs obtain loan contracts that demand high repayment in good times and low repayment in bad times. As a result, banks overinvest and generate large macroeconomic risks, even if the underlying productivity risk is small or zero.