Risk and Macro Finance: Giorgia Piacentino (Washington University in St Louis)
We present a banking model in which bank debt circulates in secondary markets, facilitating trade. The key friction is that secondary market trade is decentralized, i.e. bank debt is traded over the counter like banknotes were in the nineteenth century and repos are today. We find that bank debt is susceptible to runs because secondary market liquidity is fragile, and subject to sudden, self-fulfilling dry-ups. When debt fails to circulate it is redeemed on demand in a “money run.” Even though demandable debt exposes banks to costly runs, banks still choose to issue it because it increases their debt capacity: the option to redeem on demand increases the price of debt in the secondary market and hence allows banks to borrow more in the primary market—i.e. demandability and tradeability are complements, unlike in existing models.
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