Research

Abstract: We develop a dynamic adverse selection model where banks face credit and interest-rate risks, and depositors update beliefs via noisy signals. The optimal liability structure pairs rate-sensitive demand deposits with withdrawal-penalized Certificates of Deposit (CDs). This menu endogenously generates state-contingent outcomes that prevent inefficient liquidation during credit downgrades while preserving favorable rollover pricing after upgrades. This mechanism minimizes cross-subsidies extracted by low-quality banks, implying that riskier banks optimally rely more heavily on CD funding. We corroborate these predictions by documenting a strong predictive relationship between risk-weighted assets and uninsured CD issuance in U.S. banks. Finally, introducing depositor heterogeneity, we provide an informational microfoundation for FDIC insurance: state-contingent premiums mimic sophisticated market discipline, neutralizing unsophisticated capital frictions and restoring allocative efficiency.

Abstract: We develop a theory that explains why banks are optimally designed to have fragile liabilities, such as runnable deposits, and opaque assets, the value of which is privately observed by the bank itself. We identify conditions under which fragility and opacity together implement second-best efficient allocations and outperform direct lending in private credit markets in the presence of asymmetric information between borrowers and lenders. Specifically, opacity and fragility work together to prevent banks from facing a soft budget constraint problem whenever the credit market is sufficiently risky. In contrast, direct lending dominates intermediated bank finance whenever the credit market is sufficiently safe. Our new channel for why opacity and fragility are central in banking activities generates novel, testable implications, and overturns standard intuition from existing models prevalent in the banking literature.

Abstract: Opacity is key in bank funding. It facilitates the provision of liquidity to impatient depositors while stimulating investment in profitable but illiquid and risky assets. Utilizing a dynamic model featuring non-state contingent debt and unobservable asset monitoring effort, this paper demonstrates that deposit diversification endogenously generates opacity regarding asset quality. By mitigating severe non-linear debt overhang during interim liquidity shocks, this opacity allows banks to efficiently transform maturity and create liquidity. The model yields several empirical predictions: greater deposit diversity shortens the duration of bank liabilities, expands lending, enhances bank value, and mitigates default risk. Ultimately, these theoretical findings provide a unified framework that rationalizes recent empirical evidence on the geographical diversification of bank funding.