Research

Abstract: Banks have superior information on asset quality, while bank investors update their beliefs based on non-contractible signals over time. In this environment, I show that Certificates of Deposits (CDs) arise as part of the optimal liability structure in bank finance. Essentially, CDs allow for maturity transformation while mitigating solvency risks in case of early withdrawals. In other words, they are structured to correlate investors’ withdrawal decisions with asset quality. This, in turn, minimizes the cross-subsidies from high- to low-quality banks, as it provides insurance to high-quality banks against negative shocks that could cause disintermediation or costly liquidation, thus improving allocative efficiency. The model predicts that riskier banks rely more on CD funding relative to other types of deposits, as suggested by their balance sheet data.

Abstract: We develop a theory that explains why banks are optimally designed to have fragile liabilities, consisting in runnable deposits, and opaque assets, the value of which is privately observed by the bank itself. We show that fragility and opacity are jointly necessary to implement efficient, second-best allocations 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, more trasparent intermediaries, such as fintech lenders, dominate bank lending 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. In a dynamic model with asset monitoring, we show that deposit diversification endogenously creates opacity about asset quality. This, in turn, allows banks to create liquidity and efficiently transform maturity (Dang et al. (2017)). Several empirical predictions follow. Higher deposit diversity leads to (i) more liquidity creation (shorter term liability structure); (ii) higher bank value; and (iii) lower default risk. Empirically, these predictions are consistent with the evidence on the geographical expansion of banks.