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An Incentive Problem in the Dynamic Theory of Banking

Ernst-Ludwig von Thadden

FAME Research Paper Series from International Center for Financial Asset Management and Engineering

Abstract: This paper develops a continuous-time model of liquidity provision by banks, in which customers can deposit and withdraw their funds strategically. The strategic withdrawal option introduces an incentive-compatibility problem that turns the problem of designing deposit contracts into a non-standard, non-convex optimal control problem. The paper develops a solution method for this problem and shows that, in this more general frame-work, the insights obtained from the traditional banking models change considerably, up to the point of liquidity provision becoming impossible. The continuous-time framework allows to discuss the problem elegantly and may help to make this part of the banking literature more operational in the sense of modern asset pricing theory.

Keywords: Liquidity; deposit contracts; banking; incentive compatibility; continuous time; dynamic programming (search for similar items in EconPapers)
JEL-codes: D51 D92 G20 G21 (search for similar items in EconPapers)
Date: 2000-12
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Journal Article: An incentive problem in the dynamic theory of banking (2002) Downloads
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