Journal of Banking & Finance 31 (2007) 81101

www.elsevier.com/locate/jbf

Financial contagion and the role of the central bank

Fabio Castiglionesi
Center and Tilburg University, Finance Department, Box 90153, Tilburg 5000 LE, The Netherlands
Received 1 November 2004; accepted 31 March 2005
Available online 12 June 2006

Abstract
We investigate the role of a central bank (CB) in preventing and avoiding nancial contagion.
The CB, by imposing reserve requirements on the banking system, trades o the cost of reducing
the resources available for long-term investment with the benet of raising liquidity to face an
adverse shock that could cause contagious crises. We argue that contagion is not due to the structure
of the interbank deposit market, but to the impossibility to sign contracts contingent on unforeseen
contingencies. As long as incomplete contracts are present, the CB may have a useful role in curbing
contagion. Moreover, the CB allows the banking system to reach rst-best allocation in all the states
of the world when the notion of incentive-eciency is considered. If the analysis is restricted to constrained-eciency, the CB still avoids contagion without, however, reaching rst-best consumption
allocation. The model provides a rationale for reserve requirements without the presence of at
money or asymmetric information.
 2006 Elsevier B.V. All rights reserved.
JEL classication: E58; G20
Keywords: Contagion; Reserve requirements; Bank crisis

1. Introduction
Various theoretical interpretations have been proposed in order to give a rationale for
nancial contagion. Financial systems seem to be particularly vulnerable to systemic risk
given their characteristics: the structure of bank balance sheets, the network of exposure

E-mail address: fabio.castiglionesi@uvt.nl

0378-4266/$ - see front matter  2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2005.03.025

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

among nancial institutions, and the character of nancial contracts. Although a general
paradigm has not yet emerged, we have a better understanding of the propagation of
shocks in the banking and payment system.1 In this paper, we focus the attention on nancial institution linkages, in particular the interbank deposit market, that are able to generate the possibility of contagion. In this context, we analyze the possible role for the
central bank (henceforth CB) in preventing and avoiding bank crises and contagion.
From the early contribution by Diamond and Dybvig (1983), there is a shared view of
banks as providers of liquidity. Banks, in this context, are pools of liquidity and their
existence is not rooted in the presence of information asymmetries in credit markets.2
However, the DiamondDybvig model treats the whole banking industry as a single
entity. In reality there are many banks in dierent regions, and problems arising in one
bank can spread through the entire banking system. Financial contagion can be induced
by an information-based mechanism. Diculties in one bank may cause depositors to suspect that the whole bank industry is under pressure. For example, Jacklin and Bhattacharya (1988) argue that bank runs are triggered by asymmetry between the banks
knowledge about its depositors liquidity needs and the depositors information about
the banks asset. Chen (1999) argues that information externalities are important in causing contagious bank runs, since they force depositors to respond to noisy information such
as failures of other banks. However, nancial contagion is possible even without the presence of asymmetric information.
Allen and Gale (2000) provide an explanation of nancial contagion as a phenomenon
that emerges in the banking system of a multi-region economy. Contagion can be the equilibrium outcome in which, after the distress of a region due to an adverse shock on agents
preferences, there is the possibility of a spillover in other regions because of the presence of
cross-holding interbank deposits. The interbank deposit market is able to provide insurance to the dierent regions against asymmetric liquidity needs, thus allowing the economy
to reach rst-best allocation in a decentralized setting. However, this arrangement is vulnerable to nancial contagion if the unexpected liquidity shock occurs. Then we can ask
the following question: Is there any instrument that is able to avoid contagion in the most
ecient way? We show that the CB could oer a solution.
The intervention of the CB takes the form of reserve requirements, which are a fraction
of the amount of the banks deposits. The reserve requirements imposed on the banking
system imply that less resources can be allocated in long-term productive activities. However, the reserves give the opportunity for the CB to face the adverse liquidity shock. Then
the problem of the CB is to choose the optimal fraction of reserve requirements that, on
the one hand, ensures enough liquidity in case of an aggregate liquidity shortage occurs
and, on the other hand, does not divert too many resources from protable investment
opportunities.
The intervention of the CB allows the decentralized banking system to reach rst-best
allocation when contingent contracts are considered. Indeed, when there is no shortage of
aggregate liquidity, the imposition of reserve requirements delivers the ecient consumption allocation, making the payment to early (late) consumers higher (lower) than what the
decentralized banking system alone would oer. When the unexpected shortage of aggre1

See Rochet and Tirole (1996), Allen and Gale (2000), Freixas et al. (2000), and Dasgupta (2004).
The alternative view of banks as agents who provide delegated monitoring services is due to Diamond (1984)
and Williamson (1986).
2

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

83

gate liquidity occurs, and consequently the possibility of contagion arises, the CB
intervenes declaring the insolvency of the banking system, and guarantees rst-best
consumption level with the liquidity collected by means of reserve requirements. If we
restrict attention to non-contingent contracts, consequently shifting from the notion of
incentive-eciency to constrained-eciency, reserve requirements alone allow the CB to
avoid contagion when the aggregate liquidity shortage occurs. No declaration of insolvency is needed. However, in this case it is impossible to achieve rst-best consumption
allocation.
The underlying assumption is that the CB has a dierent a-priori about the possibility
of the occurrence of the aggregate liquidity shortage. While depositors and commercial
banks give a probability zero to this event to happen, the CB attaches to the occurrence
of this event its true (small) probability. The reason to assume a dierent a-priori is
because it makes depositors and banks to sign incomplete deposit contracts, that is they
do not take into account the liquidity shock, which appears to be a widespread characteristic of real world deposit contracts. The CB, observing this contract incompleteness, and
being worried by the occurrence of an aggregate liquidity shortage, can take the appropriate action.
Allen and Gale (2000) claim that the possibility of contagion is related to the structure
of the interbank deposit market. The more complete is the structure of the interbank
deposit market, the more dicult it is for contagion to occur. This may incorrectly suggest that a complete interbank deposit market may essentially eliminate contagion, thus,
reducing the need for a CB. It will be argued that contagion is not rooted in the structure
of the interbank deposit market, but in the impossibility for agents to sign contracts contingent on unforeseen contingencies. This result is consistent with Dasgupta (2004), who
also argues the necessity of a CB despite a complete structure of the interbank deposit
markets.
In this paper, the CB does not nd its rationale on the failure of the ex-post loan market, as in Bhattacharya and Gale (1987). The CBs role is rooted in the bad distribution of
liquidity among dierent regions, and its intervention is designed to avoid a coordination
problem in the same fashion as Diamond and Dybvig (1983), i.e., one that is caused by an
aggregate liquidity shock. There is, however, a distinction between the two models. In Diamond and Dybvig (1983) the intervention of the CB takes the form of deposit insurance
since this is enough to avoid the bad equilibrium (i.e., the bank runs) in the presence of
multiple equilibria. In this model, the intervention of the CB needs to be more explicit
through reserve requirements.
There is an authoritative doctrine claiming that reserve requirements are useless, at least
from the point of view of monetary policy (Sargent and Wallace, 1982). However, various
monetary models have provided a rationale for reserve requirements. For example, they
reduce the nominal instability generated by a monetary policy that targets interest rate stabilization. In this context, reserve requirements are a useful companion to interest rate
stabilization (Lorenzoni, 2001). Moreover, reserve requirements make the money market
multiplier more stable and predictable, thus helping to control money and credit expansion (Brunner and Meltzer, 1990). Alternatively, a scope for a regulatory intervention
by means of reserve requirements can derive from the fact that banks are characterized
by costly state verication (Di Giorgio, 1999).
In our model, there is no need of at money injections in order to rationalize the presence of reserve requirements. Consequently, a rationale for the introduction of a legal

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

reserve requirement is obtained in a real (non-monetary) model. Moreover, in our

model banks do not face asymmetric information problems on the activities side of
their balance sheets since they invest directly in productive assets. Finally, since the CB
successful intervention does not rely on liquidity creation, no direct transfers from taxpayer are necessary in order to bail out the distressed region (contrary to Freixas
et al., 2000). In our model, the cost is represented by the missed long-term investment
opportunity.
The paper is organized as follows. In Section 2, we present the model, which builds on
Allen and Gale (2000). In Section 3, we characterize the optimal risk-sharing solution
obtained by the social planner. In Section 4, the decentralized economy with the CB is analyzed. In Section 5, we compare the nancial fragility of the decentralized economy with
and without the intervention of the CB. In Section 6, we restrict the analysis to non-contingent contracts, considering then the notion of constrained-eciency, rather than incentive-eciency, as the benchmark. Finally, we draw the conclusions.
2. The model
Consider an economy with one good, which serves as numeraire, and a continuum of
consumers (depositors). There are three dates: a planning period (t = 0) and two consumption periods (t = 1, 2). All consumers are endowed with one unit of the good at period 0.
There are two types of assets, which are represented by storage technologies. A liquid asset
(the short asset) that takes one unit of the good at date t and converts it into one unit of the
good at date t + 1; and an illiquid asset (the long asset) that takes one unit of the good at
date 0 and transforms it into R > 1 units of the good at date 2. If the long asset is liquidated prematurely at date 1, then it pays 1 > r > 0 units of the good. Only banks can invest
in nancial assets, and consumers have to deposit their endowment in a bank in order to
take advantage of the available investment opportunities.
There are four regions (labeled A, B, C, and D) that are ex-ante identical but dier in
the liquidity shock. Each region contains a continuum of ex-ante identical consumers and
a continuum of identical banks. Agents are assumed to have DiamondDybvig preferences, that is,

uc1 with probability xi
U c1 ; c2
uc2 with probability 1  xi :
The function u() is assumed to be increasing, strictly concave, twice continuously dierentiable, and satises the Inada conditions. The probability xi is the random fraction of
early consumers in region i, and it can take two possible values xH and xL, with
xH > xL. Let the average fraction of early consumers be dened by c  (xH + xL)/2.
The realization of the liquidity preference shocks is state-dependent, and is given in
Table 1.
There are two equally likely states, S1 and S2, with probability p1 and p2, respectively,
and a low-probability state S with probability p3. The latter state represents a perturbation of the model, such that the aggregate demand for liquidity is greater than the systems
supply of liquidity. While the state of nature S is given a probability zero by commercial
banks and depositors, the CB attaches to it the true, small, probability. This implies that
commercial banks and depositors do not consider this event in the deposit contract, how-

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

85

Table 1
Regional liquidity shocks

S1
S2
S

xH
xL
c+e

xL
xH
c

xH
xL
c

xL
xH
c

ever the CB is concerned with the consequences of the low-probability aggregate shortage
of liquidity.3
Ex-ante, each region has the same probability of having a high liquidity preference.
There is no aggregate uncertainty for commercial banks and depositors. All uncertainty
is resolved in t = 1, when the state of nature is revealed and each consumer learns whether
she is an early or late consumer. A consumers type is not observable, so late consumers
can always imitate early consumers.
The role of the banks is to make investments on behalf of consumers and to ensure
them against liquidity shocks. In t = 0 each bank oers a deposit contract (c1, c2), which
allows depositors to withdraw either c1 units of consumption in t = 1 or c2 units of consumption in t = 2, and invests the deposit in a portfolio (x, y), where x and y are the
per capita amounts invested in long and short assets, respectively. The CB imposes in
t = 0 to each bank reserve requirements q. The timing of the contract in t = 0 is as follows.
First, depositors and banks sign the deposit contract, and banks decide the investment
portfolio. Both the consumption level and the investment are contingent on the value of
the reserve requirement. Second, the CB xes the reserve q. Third, deposit contracts
and investments are implemented. This kind of deposit contract is like a deposit with variable interest rate, which are observed in reality. When depositors and banks sign the
deposit contract they take as a parameter the aggregate condition of the economy that
here is represented by q. Once reserve requirements are chosen by the CB, the contracts
are implemented in t = 0, before the realization of the state of nature, and the consumption levels in t = 1 and t = 2 are determined.
3. Optimal risk-sharing
The optimal risk-sharing can be characterized by the solution of the planners problem,
given that a central planner can easily transfer resources across regions. Suppose that the
planner can observe the agents type, so that we do not need to consider the incentive compatibility constraints. Since consumers are ex-ante identical, the planner is assumed to
maximize the unweighted sum of consumers expected utility in all the possible states of
nature. The planners problem is

Through the paper we will assume that the CB knows both the probability of the occurrence of the aggregate
liquidity shortage (p3) and the value of the shock e. The results that are obtained in what follows are robust if we
consider a stochastic value of the liquidity shock. That is, the CB does not know the value of the shock but only
its distribution. This extension is available upon request from the author.

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

max

fx;y;c1 ;c2 ;c1 ;c2 g

subject to:

p1 p2 cuc1 1  cuc2  p3

h

i

e
e
uc1 1  c  uc2
4
4

x y 6 1;
cc1 6 y;

e
c c1 6 y;
4
1  cc2 6 Rx;

e
1  c  c2 6 Rx;
4

where c1 and c2 are the consumption levels in the expected states of nature S1 and S2, while
c1 and c2 are those in the low-probability state S. The problem of the central planner assumes that no early liquidation of the long-term asset is ever implemented. The implicit
assumption is that the cost of early liquidation r, even if greater than zero, is suciently
small that liquidation of the long-term asset is never optimal. The solution to this problem
is the rst-best solution.
The planner optimally chooses the investment in the nancial assets, adjusting consumption contingent on the state of nature that occurs. This implies that the constraints
are binding and the rst-best solution is characterized by the following allocation:

e
y  cc1 c c1 ;
4
e
x 1  cc1 1  c c1 ;
4
cc1
c1
;
c 4e
R1  cc1
;
c2
1c
R1  cc1
c2
:
1  c  4e
On the one hand, the rst-best solution is characterized by a larger amount of consumption in t = 1 when there is no aggregate liquidity shortage (c1 > c1 ). If more than expected
early consumers want to withdraw, then a lower amount of consumption should be given to
them. This captures the idea that when a shock occurs (able to cause a crisis) then it is optimal to reduce consumption, since it allows to avoid the costly liquidation of the long-term
asset. On the other hand, the rst-best solution gives more consumption to late consumers
in case of the liquidity preferences shock than in the normal states (c2 > c2 ). This because
the same amount of resources is available for the less-than-expected late consumers.
Proposition 1. If the probability of the unexpected state S is sufficiently small, then the firstbest allocation d y  ; x ; c1 ; c2 ; c1 ; c2 is equivalent to the incentive-efficient allocation in
all the states of the world. The first-best allocation can be achieved even if the planner cannot
observe the consumers type.
Proof. The FOCs of the planners problem lead to the following condition:
p1 p2 Ru0 c2  u0 c1  p3 u0 c1  Ru0 c2 :

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

87

First of all, note that the optimal allocation gives c1 > c1 and c2 > c2 . Therefore, if the incentive compatibility c2 > c1 is satised then the other incentive compatibility condition c2 > c1
is also satised. Moreover, if the condition c2 > c1 is violated the condition c2 > c1 still holds.
In fact, suppose c1 > c2. Then Ru 0 (c2) > u 0 (c1), which in turn implies, from condition (1),
u0 c1 > Ru0 c2 , which in turn implies c2 > c1 . Therefore, we have to rule out c1 > c2, which
is in principle possible. From condition (1), it is clear that for p3 = 0 the rst-best allocation
implies Ru 0 (c2) = u 0 (c1), which in turn implies c2 > c1. Then, when p3 = 0 we have c2 > c2 >
c1 > c1 , or u0 c1 > u0 c1 Ru0 c2 > Ru0 c2 . Therefore, in this case incentive compatibility is satised in all the states of the world. The objective function is strictly concave, so that
for each p3 there is a unique solution dp3 c1 p3 ; c2 p3 ; c1 p3 ; c2 p3 . By the maximum
theorem, d(p3) is a continuous function of p3. Thus, as p3 ! 0, we have d(p3) ! d(0). This in
turn implies that, since the incentive compatibility inequalities are satised with strict
inequality at p3 = 0, they will also be satised in an open neighborhood of zero. h
We consider as benchmark the notion of incentive-eciency until Section 6, where we
analyze the case in which the planner is restricted to use non-contingent contracts. In that
context, we will see how results change if the notion of constrained-eciency is considered
as the appropriate benchmark.
Example 1. Let us characterize the rst-best solution with the logarithmic utility function
u() = log(c). The planners problem can be written as



R1  cc1
max p1 p2 c logc1 1  c log
fc1 g
1c
8
2
3
2
39
>
>
=
<



e
e
6 cc1 7
6R1  cc1 7
p3
c log 4
5 1  c  log 4
5 :
e
e
>
>
4
4
;
:
c
1c
4
4
Taking the FOC, we get the rst-best consumption in the expected states:
pe
c1 1 3 :
4c
Accordingly, the rst-best allocation in case of logarithmic utility function is


p3 e
pe

y c 1
c 3 ;
4c
4
p
e
x 1  c  3 ;
4
p3 e
c
4 ;
c1
e
c
4
h
p ei
R 1c 3
4 ;
c2
1c
h
p ei
R 1c 3
4
c2
e :
1c
4

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

Note that c1 > 1 > c1 and c2 > c2 . Moreover, at p3 = 0 we have c2 = R > 1 = c1 and
1c
c
c2 R 1c
c1 ; so that both incentive compatibility constraints hold.
e > R > 1 > c e 
4
4
The inequalities still hold for p3 low enough. Since c2 > c1 implies c2 > c1 ; the threshold
level p3 is given by
p3 6 p3

4c1  cR  1
:
e ecR  1

For values of p3 higher than p3 the incentive compatibility constraint c2 > c1 does not hold
anymore.
4. Decentralized economy
The rst-best allocation can be decentralized by a competitive banking system with the
presence of the CB. Since in each region there is a continuum of identical banks, it is possible to focus on symmetric equilibria. The decentralized allocation is then characterized in
terms of the behavior of a representative bank in each region.4
Agents deposit their endowment in the representative bank of their region. Each representative bank oers them a deposit contract (c1, c2), and it invests the deposits in the portfolio (x, y). As already mentioned in Section 2, the timing of the contract in t = 0 is as
follows. First, depositors and banks sign the deposit contract, and banks decide the investment portfolio. Both the consumption level and the investment are contingent on the value
of reserve requirements q. Second, the CB determines q. Third, deposit contracts and
investment portfolio are implemented before the realization of the state of nature. Clearly,
the deposit contract has to respect the incentive compatibility constraint.
The reserve requirements imposed by the CB represent the minimum amount of deposits
that the commercial banks have to invest in the short-term liquid asset. Then, the
resources xed as reserve requirements pay one unit of consumption both in t = 1 and
in t = 2. The CB xes reserve requirements for precautionary reasons, in order to prevent
aggregate liquidity shortages. Commercial banks correctly anticipate that the CB is a
benevolent institution that maximizes social welfare, and they rationally expect to use in
t = 1 the amount of reserves to face early consumers.
In t = 0 the representative banks have the budget constraint x + y 6 1  q, which is satised by all of them. However, the budget constraint in the second period, namely cc1 6 y,
is not satised by the regions that have a high proportion of early consumers because
xHc1 > cc1 = y. The advantage of the planner is that he can move consumption between
regions so (in the expected states) he needs to satisfy only the average constraint
cc1 = y. As shown by Allen and Gale (2000), the way to overcome this problem is to introduce an interbank market for deposits that is, banks of dierent regions exchange deposits among themselves at t = 0. Two possible structures of the interbank deposit market are
considered: complete and incomplete (see Fig. 1).
In the case of complete markets, each region exchanges deposits with all the other
regions. Each region is negatively correlated with two other regions, therefore it is

For expositional purposes, in this section we analyze the decentralized allocation in states S1 and S2, dealing
with the analysis in the unexpected state in the next section.

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

Complete Market

89

Incomplete Market

Fig. 1. The interbank deposit market.

assumed that each representative bank in region i holds zi = (xH  c)/2 deposits in all the
other three regions. In the case of incomplete markets each region holds deposits only in
the adjacent region. Each bank is then assumed to hold zi = (xH  c) deposits in the adjacent region. In both market structures, we have zi = z "i (all the regions hold the same
amount of interbank deposits). Note that the amount of deposits exchanged in the interbank deposit market does not depend on the reserve q.
With a competitive market for deposits, a decentralized banking system will oer
deposit contracts that maximize the expected utility of consumers. The deposit contract
oered will solve the following problem:
max

fx;y;c1 q;c2 qg

cuc1 q 1  cuc2 q

subject to the following three feasibility constraints:

xq yq 6 1  q;
q 6 cc1 q 6 yq q;
1  cc2 q 6 Rxq:
The constraints are faced by the representative banks in t = 0, t = 1, and t = 2, respectively. The bank takes as given reserve requirements imposed by the CB to the banking
system, and invests in t = 0 an amount 1  q in the portfolio (x, y). Since, for given q
(for each value of the reserve xed by the CB), the total amount of consumption provided
in each period is constant, it is optimal to provide for consumption at t = 1 by holding the
short asset (represented now by the amount invested in y plus the reserve imposed by the
CB), and to provide for consumption at t = 2 by holding the long asset.
The constraint in t = 1 can be explained as follows. Without the help of the CB (i.e.,
with q = 0), commercial banks would provide an amount of liquidity in t = 1 equal to
cc1(0). As long as the imposed reserve by the CB is less than cc1(0), commercial banks will
invest cc1(0)  q in the liquid asset and the rest in the long-term asset. On the other hand,
if the reserve is greater than cc1(0) the banks nd it optimal not to invest in y that is,
y(q) = 0. This because commercial banks rationally expect the CB to let them use the
reserve for liquidity need in t = 1. However, if cc1(0) 6 q less resources are available to
invest in the long asset, reducing consumption for late consumers. This represent the cost
of imposing reserve requirements. We indicate the solution to this problem as the allocation d(q) that is characterized as follows:

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101


yq

cc1 0  q

when q < cc1 0

0 when q P cc1 0;
8
>
< yq q c 0 when q < cc 0
1
1
c
c1 q
>
: q when q P cc1 0;
c

1  cc1 0 when q < cc1 0
xq
1  q when q P cc1 0;
8
R1  cc1 0
>
>
c2 0 when q < cc1 0
<
1c
c2 q
>
R1  q
>
:
when q P cc1 0:
1c

It is clear that, if the CB wants to aect the decentralized allocation decision made by
the commercial banks, it has to x reserve requirements greater than cc1(0). In this way the
CB can raise consumption in t = 1 and reduce consumption in t = 2. A reserve requirement less than cc1(0) would not change the asset and consumption allocation chosen by
representative banks. On the other hand, the CB cannot x a q too high otherwise incentive compatibility could be violated. Indeed, the incentive-ecient allocation can be
achieved by the banking system with the presence of the CB.
cR
Proposition 2. As long as the reserve is q 6 1ccR
< 1, the decentralized allocation
d(q) = {x(q), y(q), c1(q), c2(q)} is equivalent to the incentive efficient allocation c1(q) 6 c2(q).
The allocation can be achieved even if the representative banks and the CB cannot observe
consumers type.

Proof. The representative banks problem can be rewritten as follows:



R1  cc1 q
max cuc1 q 1  cu
fc1 qg
1c
subject to q 6 cc1(q). The solution satises the FOC:
u0 c1 q u0 c2 qR  l;
where l is the Lagrangian multiplier of the constraint. If the CB xes a reserve q < cc1(0)
then c1(q) = c1(0) and c2(q) = c2(0), and the constraint is slack, i.e., l = 0. The incentive
compatibility condition c2(q) P c1(q) is always satised since R > 1. When the CB imposes
a reserve q P cc1(0) then representative banks are forced to overinvest in the short-term
asset, reducing the resources allocated in the long-term asset. This changes consumption
allocation, and the incentive compatibility condition c2(q) P c1(q) now implies
R1  q
q
P :
1c
c
cR
This condition is satised if and only if q 6 1ccR
.

Example 2. With utility function u() = log(c) we have c1(0) = 1 and c2(0) = R. Therefore,
the allocation is

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101


yq

cq

91

when q < c

0 when q P c;
8
< 1 when q < c
c1 q q
when q P c;
:
c

1  c when q < c
xq
1  q when q P c;
8
< R when q < c
c2 q R1  q
:
when q P c:
1c

Note that with logarithmic utility function we have c1 > c1 0 > c1 , and c2 > c2 0 > c2
(both for q < c ). This means that the decentralized solution does not reach the rst-best
allocation when the reserve requirement xed by the CB does not bite the investment
decision made by the commercial banks in the liquid asset.
We have proved that the decentralized solution is incentive compatible, and it is possible to show that the constraints faced by the representative banks in t = 1 and t = 2 are
always satised in the states S1 and S2. Consequently, the same decentralized solution
d(q) can be achieved by both interbank deposit market structures. We leave this easy task
to the reader.
Let us now deal with eciency, comparing the decentralized solution d(q) with the rstbest solution d*. The decentralized solution with the intervention of the CB delivers the
rst-best allocation when banks and depositors assign zero probability to state S.
Proposition 3. The decentralized economy, with the CB fixing a reserve requirement
qCB = y*, reaches the first-best allocation in states S1 and S2. The decentralized allocation
d(q) coincides with the first-best allocation d*.


Proof. Recall that rst-best consumption allocation is c1 yc and c2 R1y

: In the
1c
decentralized solution the contract oered by the banks depend on q and it is equal to


yq

cc1 0  q

when q < cc1 0

0 when q P cc1 0;
8
yq q
>
>
when q < cc1 0
<
c
c1 q
q
>
>
:
when q P cc1 0;
c

1  cc1 0 when q < cc1 0
xq
1  q when q P cc1 0;
8
R1  cc1 0
>
>
when q < cc1 0
<
1c
c2 q
>
>
: R1  q when q P cc1 0:
1c

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

If the reserve is less then cc1(0) then y(q) < y*. In fact, when q = 0, we have
y(q) = cc1(0) < y* since c1(0) < c1 (in the rst-best solution more consumption is optimally
allocated to early consumers). Now, all the values of q less than cc1(0) do not change the
decentralized consumption allocation in t = 1 and then y(q) < y*. In order to change allocation the CB has to x a reserve greater than cc1(0). It is clear that c1(q) = c1 and
c2(q) = c2 when q = y* > y(q) = cc1(0). When q = y*, then also the investment in the
long-term asset is equal to the rst-best since x(q) = 1  q = 1  y* = x*. h
The intervention of the CB allows the decentralized banking system to reach rst-best
allocation because banks and depositors sign incomplete deposit contracts, which would
deliver lower (higher) consumption to early (late) consumers with respect to how it would
be optimal if complete contracts were signed. Note that the CB and the decentralized
banking system are able to oer the rst-best allocation d*, independently of the structure
of the interbank deposit market. Finally, since qCB is equal to y*, the optimal reserve is
also an increasing function of p3. For a small value of this probability, the condition on
q stated in Proposition 2 will be satised and also the incentive compatibility constraint
holds.
Example 3. With the logarithmic utility function, the rst-best consumption allocation is
p e
R1c 43
given by c1 1 p4c3 e and c2
: The investment in the short-term asset is
1c
y  c p43 e. Then qCB c p43 e : Accordingly, the consumption allocation in the decentralized economy is
c1 qCB

qCB
pe
1 3 c1
4c
c

c2 qCB

R1  qCB R1  c 

1c
1c

and
p3 e

c2 :

Then, with logarithmic utility function, we have the following condition:

0 < qCB c

p3 e
cR
<
< 1;
4
1  c cR

which for p3 sufciently small is always satised.

5. Financial fragility
We analyze now the occurrence of the unexpected state S, and we assume for simplicity
that the interbank deposit market structure is incomplete. The decentralized economy
delivers the allocation d(q), and the CB can reach rst-best allocation by xing qCB = y*
(Proposition 3). However, in state S there is an aggregate liquidity shortage in t = 1, and
banks have to pay c1(q) units of consumption to whomever withdraws. If they cannot do
so, they must liquidate all or part of their respective assets. Following Allen and Gale
(2000), the order of liquidation of the assets is as follows: rst, the short asset, then the

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93

cross-holding deposits, and, nally, the long asset.5 In order to ensure that this pecking
order is observed, we assume that r is small enough, so that for each q in the relevant
range we have Rr > cc21 q
> 1.
q
5.1. Financial fragility without the CB
Allen and Gale (2000) have analyzed the case in which q = 0 and the banks are forced
to liquidate the long-term asset when they do not have enough liquidity. The analysis can
be summarized as follows.
Let qi be the fraction of the value of deposits in the representative bank in region i at
t = 1, i.e., each depositor with a claim worth $1 is actually able to withdraw 0 6 qi 6 1 dollars. Since the proceeds of the deposits are assumed to be split proportionally, qi must be
determined simultaneously for all regions by the two sides of the market. The fraction qi is
determined in equilibrium equating the total demand with the total supply of liquidity. As
long as the total supply is greater (or equal to) the total demand of liquidity then qi = 1. If
total demand is greater than total supply of liquidity, we have qi < 1, and the region is
bankrupt in t = 1. In the latter case, qi represents the liquidation value of the banks assets.
Consider, for example, region A. Depositors of region A have claims worth 1 towards
the bank, while the bank in region D has claims worth z. Let b
c A1 be the amount that consumers of region A desire to withdraw from the bank at time 1, and bz A the amount that
bank D desires to withdraw. Thus, b
c A1 bz A is the total demand for liquidity. The total supply is given by region As asset (short and long) plus its holding in region B that is,
y + rx + zqB. Therefore, if b
c A1 bz A 6 y rx zqB then bank of region A is able to meet
B
the demand for liquidity, and qA = 1. Otherwise qA yrxzq
, and the upper bound of
bc A1 bz A
the liquidation value of region A under bankruptcy is given by qA 6 qA yrxz
, namely
bc A1 bz A
B
A B C D
when region B is not bankrupt (i.e., q = 1). Notice that, as observed above, (q , q , q , q )
have to be determined simultaneously. Furthermore, the demands bc i1 and bz i are also determined endogenously.
When the state of the world is either S1 or S2 then bc i1 bz i y  in each region, so that
i
q = 1 for all i. However, when S occurs the global demand for liquidity exceeds the total
amount invested in the short-term asset. This implies that some quantity of the long-term
asset has to be liquidated.6 Notice, however, that the demand for liquidity in t = 1 may
increase, since late consumers may opt for early withdrawal if they fear that early liquidation of the long-term asset will reduce the payo in t = 2 The maximum amount of the
long-term asset that can be liquidated at t = 1 without triggering a bank run by late consumers is x  1  x c1R0. In fact, the representative bank has to give at least c1(0) to late
consumers in t = 2 (otherwise, they would withdraw in t = 1). Therefore, a bank with x
early consumers keeps at least 1  x c1R0 units of the long asset. The maximum amount
5

Therefore at t = 1, the representative bank may be in any one of the following situations: solvent (if it can meet
the demand with the short asset plus the deposits held in the other region); insolvent (if it has to liquidate some of
the long asset); or bankrupt (if it cannot meet the demand after liquidating all assets).
6
Deposits from the interbank market are of no use in the unexpected state. In fact, once region A withdraws its
interbank deposits from region B to pay its early consumers, region B is forced to withdraw its amount of
interbank deposit from region C and so on. Since no representative bank wants to liquidate the long asset if it can
be avoided, all banks simultaneously withdraw their deposits in banks in the other regions in t = 1. These mutual
withdrawals oset each other, so each region is forced to be self-sucient.

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

of consumption
by liquidating the long asset without causing a run is
h that can be obtained
i
then bx r x  1  x c1R0 : In state S, the representative bank in region A is able to
meet demands from early consumers, without help from other regions, if, and only if,
ec1(0) 6 b(c + e). If this condition is violated, then region A is bankrupt and the possibility
of contagion arises.
Proposition 4. Consider the incomplete market structure of the interbank deposits market
and perturb it with a zero-probability state S. Suppose that each representative bank chooses
first-best investment portfolio and offers first-best consumption allocation through deposit
contracts. If the following two conditions, regarding region As bankruptcy and spillover to
region D respectively, are satisfied: (a) ec1(0) > b(c + e); (b) z1  qA > bc, then, in any
continuation equilibrium, the representative banks in all regions are bankrupt at date 1 in
state S.
Proof. See Allen and Gale (2000). h
Contagion occurs under more restrictive conditions if the structure of the interbank
deposit market is complete. In this case the cross-holding is z = (xH  c)/2, which is smaller than the amount requested in incomplete markets [z = (xH  c)].
A possible remedy to avoid contagion could be that each region in t = 0 commits itself
(directly with the other regions, or through the CB) to provide the liquidity according to
the state of nature that occurs. This mechanism lacks of ex-post credibility. In fact, in
states S1 and S2, it is not optimal for the regions to deviate from the commitment (otherwise they would have to liquidate their long-term asset, which is more costly than liquidating the cross-holding deposits). However, it is optimal to deviate in state S. In this case, the
three regions that are not hit by the shock have an incentive to deviate in order not to liquidate the long-term asset (they would have to liquidate some of it in order to avoid As
bankruptcy).7 Consequently, the necessary liquidity in order to be able to intervene also in
state S has to be guaranteed in t = 0.
5.2. Financial fragility with the Central Bank
We have seen in the previous section that an unexpected aggregate liquidity shortage in
t = 1 can cause the collapse of the entire economic system. We show in this section that the
CB can prevent nancial fragility, allowing the economy to reach the rst-best allocation
also with an aggregate shortage of liquidity. The CB, by xing reserve requirements on the
amount of deposits collected by the commercial banks, can ensure that the inecient liquidation of the long-term asset is avoided. Without the costly liquidation of the long asset,
the possibility of bankruptcy and, consequently, of contagion is completely avoided. The
CB ensures that a possible nancial crisis in one region does not spill over other regions.
When the unexpected state S appears in t = 1, the representative bank in region A will
need ec1(q) units of consumption by liquidating the long asset. Without other forms of
intervention, region A can get extra-liquidity by liquidating the long-term asset only if
7

Other interventions, such as suspension of convertibility or liquidity provision by means of ex-post loans
market, do not work in preventing region As bankruptcy and contagion (see Allen and Gale, 2000).

F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

95

ec1(q) 6 b(c + e). If this is the case, late consumers in region A are worse o because the
premature liquidation of the long asset prevents to pay the promised consumption c2(q)
in t = 2. If ec1(q) > b(c + e), contagion could arise according to Proposition 4.
However, the problem can be avoided altogether if the CB can reduce the value of the
deposits of early withdrawal. In this way, the rst-best allocation can be reached. This is
done as follows. Suppose that q is suciently high, so that the deposit contract oered by
the banks gives the right to withdraw an amount qc in t = 1, and the banks do not invest in
the short-term asset (this will actually be the case when q is determined in order to achieve
the rst-best). When state S occurs, the total demand for liquidity exceeds the quantity of
reserves since 4c e qc > 4q. In this case, the CB simply states that the amount that can
be withdrawn at t = 1 is equal to cq e, and shifts part of the reserves to the region hit by the
4
liquidity shock. We have the following result.
Proposition 5. If qCB = y*, the decentralized allocation d(q) coincides with the first-best
allocation d*. In the continuation equilibrium in state S in t = 1, the CB allows region A to
face the liquidity shock avoiding the premature liquidation of the long-term asset, and
consequently the contagion outcome.
Proof. If q = y* > cc1(0) the contract offered by the banks promises a payment c1 q qc
in t = 1. The rst-best outcome is achieved when states S1 or S2 realize. It is therefore
enough to check that the rst-best outcome is achieved also
in state S. In that case the
R1y 
y

rst-best consumption allocation is c1 c
and
c

:
Now
suppose that when S
e
2
1c4e
4
y
occurs the bank reduces the value of promised payment at time 1 to c
e . In this case the
4

total demand for deposit withdrawal by early consumers is equal to the total quantity
of reserves
y
4c e
4y  ;
c 4e
so that by shifting reserves across banks appropriately, the CB can prevent liquidation of
the long-term asset in each region. When q = y*, also the investment in the long-term asset
is equal to the rst-best since x(q) = 1  q = 1  y* = x*. h
This result implies that the CB intervention avoids either the worsening of the condition
of the late consumers (in case region A is insolvent) or the possibility of contagion (in case
region A is bankrupt). The amount c1 given to the early consumers is less than what they

would expect, namely c1 q yc . This is equivalent to say that the CB declares the insolvency of the banking system in t = 1 and pays early consumers c1 . In case of a liquidity
crisis, the amount of reserves collected in t = 0 are sucient to reach eciency and the
banking system does not need extra-liquidity, which could have been obtained by liquidating the long asset or by injecting at money into the system. Using all the reserves to pay
early consumers, the CB reach rst-best consumption allocation when an aggregate shortage of liquidity occurs (as analyzed in the planner problem).8
8

Note that the declaration of insolvency does not cause any turmoil. In fact, since the CBs intervention
delivers rst-best consumption, late consumers do not run the banks because the incentive-ecient constraint
holds, and early consumers are satised with the amount they withdraw because they perfectly realize what is in
their best interest once the unexpected shock appears.

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

When there is a liquidity shock, able to determine an aggregate liquidity shortage,

then the CB need to use two instruments: reserve requirements, and the declaration
of the insolvency of the banking system. The rst tool assures the ecient level of
investment in the liquid asset y, which would not be chosen by commercial banks; the
second tool assures that in state S the level of consumption in t = 1 can be properly
reduced.9
However, if we accept the idea that crises have to be dealt with a fail safe principle
(namely, to minimize damages when a crisis occur), then reserve requirements xed by
the CB guarantee the right amount of liquidity in order to avoid contagion eciently.
Otherwise, if nancial crises have to be avoided no matter what, which in the present
model it means to allow early consumers to withdraw the promised c1(q), then no level
of reserves is sucient to avoid the risk of contagion. This because commercial banks oer
a level of consumption in t = 1 that is not feasible in the unexpected state.
Declaring the insolvency of the banking system in t = 1 can be considered an application of the fail safe principle, and xing qCB is then necessary to avoid contagion in an
ecient way. In order to clarify this statement, assume that the CB xes reserve requirements 0 6 q < cc1(0), then the consumption promised by the deposit contract in t = 1 is
c1(0). Assume also that the CB has the possibility to declare the insolvency of the system.
This kind of intervention, not only does not reach rst-best in the expected states of nature
(since c1(0) < c1), but also in the unexpected state. In fact, to avoid the crisis and the risk of
contagion the CB will allow to withdraw in t = 1 only
cc1 0
e < c1 0:
c
4
This amount is less than the ecient amount c1 , since
cc1 0
cc1
e < c1
e < c1 0 < c1 :
c
c
4
4
Without xing the optimal qCB, any ex-post intervention that prevents contagion would
be inecient and somehow arbitrary. The CB could even decide to liquidate part of the
long asset to penalize also late consumers.
Finally, it is important to notice that the role of the CB in preventing nancial crisis
and contagion does not depend on the structure of the interbank deposit market. Even
with a complete market structure, when there is an aggregate excess demand for liquidity,
region A has to be self-sucient. Consequently, the CB may improve not only upon the
incomplete interbank deposit market structure (which is quite intuitive), but also upon
the complete one. The reason for this result is that commercial banks and depositors sign
deposit contracts that are not contingent on all the states of nature. The CB becomes a
way to complete the deposit contracts, independently of the structure of the interbank
deposit market.

9
Declaration of insolvency is strictly related to the notion of incentive-eciency. Indeed, if constrainedeciency is taken into account, then declaration of insolvency is not needed in order to avoid contagion (see
Section 6).

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97

6. Constrained eciency
In Section 3, the rst-best allocation has been characterized by a planners problem,
where the planner can condition the consumption allocation on the liquidity shock.
Accordingly, the optimal level of consumption in the expected states (c1, c2) is dierent
with respect the optimal level of consumption when the unexpected liquidity shock strikes
(c1 ; c2 ). The planners investment in the short asset turns out to be higher than in the
decentralized equilibrium (y* > y = cc1(0)) to insure against the liquidity shock. To replicate the rst-best allocation, it is necessary that the CB induces commercial banks to
increase their investment in the short asset (which is achieved by mean of reserve requirements), and that, when the shock appears, commercial banks must condition their consumption payments on the liquidity shock (which is obtained by declaring the
insolvency of the banking system). The last intervention, instead of an application of
the fail safe principle, could be interpreted as suspension of convertibility. Assuming
away non-contingent contracts could be considered a way to eliminate the problem of
contagion.10
In this section, we restrict also the planner to use non-contingent (demand deposits)
contracts. In this way we consider the notion of constrained-eciency, rather than incentive-eciency, as the appropriate benchmark. The planner in t = 1 has to assure to early
consumers the amount c1 no matter what is the liquidity demand (i.e., c1 c1 ). In order to
avoid inecient waste of consumption, deposits not withdrawn in t = 1 are reinvested in
the storage liquid asset y and given to late consumers in t = 2. The level of consumption in
t = 2 then depends on how many early consumers withdraw in t = 1. However, at least the
amount c2 has to be guaranteed to late consumers. The planners problem is
h
i
e
e
max
p1 p2 cuc1 1  cuc2  p3 c uc1 1  c  uc2
fx;y;c1 ;c2 g
4
4
subject to: x y 6 1;
cc1 6 y;

e
c c1 6 y;
4
1  cc2 6 Rx y  cc1 ;


e
e
1  c  c2 6 Rx y  c c1 ;
4
4
c1 6 c2 6 c2 :
The optimal amount invested in the short asset is clearly y C c 4e c1 , since the noncontingent contract now forces the planner to hold liquidity in excess of what is required
to pay the promised consumption to the early consumers in normal times (i.e., cc1).
Accordingly, the optimal long-term investment is xC = 1  yC. The excess of liquidity is
used to provide the same level of consumption to the additional early consumers if the
aggregate liquidity shock strikes. If the shock does not realize, late consumers get
1
RxC
c2 1c
RxC 4e c1 . Otherwise, the optimal level of consumption in t = 2 is c2 1c
e.
4
C
C C
We indicate the constrained rst-best allocation as d fy ; x ; c1 ; c2 ; c2 g. It is easy to
verify that for e small enough the allocation dC satises incentive-eciency, that is c1 6 c2.
10

For a general analysis on this issue, see Allen and Gale (2004).

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

Indeed, a liquidity shock too high would reduce too much the long-term investment xC
and, consequently, the consumption for late consumers. Finally, note that for e = 0 we
C
have c2 c2 and the constraint c2 6 c2 is satised. Moreover, given that dxde  c41 , we have
R1c1
dc2
dc2
1 1R
c41c
< 0 and ddec2 41c
c2 is
e 2 . Then, for c1 6 1 it is de P 0 and the constraint c2 6 
de
4
satised for all parameters values. Otherwise, for c1 > 1, it is ddec2 < 0 and then we need the
h
i1=2
1 1c
further condition dcde2 > ddec2 , which implies 4e < 1  c  R1c
.
c1 1R
As already seen in Section 4, the imposition of reserve requirements in the decentralized
economy does not cause commercial banks to hold the excess of liquidity since they do not
anticipate the liquidity shock. Accordingly, they increase their promises to early consumers in line with their increased holdings of the short asset, so that they still have inadequate
aggregate supplies of liquidity when the unanticipated liquidity shock hits. With contingent contract, the declaration of insolvency introduced the right amount of contingency
to reach eciency and avoid contagion. Then with non-contingent contract, a dierent
reserve policy is required to protect against contagion. We dene reserves as the excess
of the short asset over the normal commitments in t = 1, that is q  y  cc1(0), where
c1(0) is the promised consumption to early consumers in the decentralized economy. Then
commercial banks provide liquidity according to the normal commitments in t = 1, and
only consumption in t = 2 depends on the reserve xed by the CB. In order to not waste
consumption, deposits not withdrawn in t = 1 are rolled over for last period consumption.
The decentralized problem is
max

fx;y;c1 0;c2 qg

cuc1 0 1  cuc2 q

subject to: xq 6 1  y  q;
0 6 y  cc1 0 6 q;
1  cc2 q 6 Rxq q:
Independently of the level of reserve requirements xed by the CB, commercial banks invest an
cc1(0) in the short asset y, which is less then the optimal amount
 amount

y C c 4e c1 since c1(0) < c1. Indeed, like in the incentive-eciency analysis, the consumption c1(0) does not take into account the possibility of the liquidity shock, while
the consumption c1 is computed considering such event. This implies that optimal consumption for early consumers should be higher than what characterized by the decentralized economy.
In order to implement the constrained rst-best investment in the short
 liquid
asset, the
CB need to impose a reserve such that y + q = yC. This implies that q c 4e c1  cc1 0.
Accordingly, also the investment in the long asset is optimal since x = 1  y  q =
1  yC = xC, so the optimal investment portfolio is achieved.
Let us analyze what happen in the expected states characterized by absence of liquidity
shock. The promised consumption c1(0) to the early consumers is obviously met. In this
case, in fact, the total demand from early consumers is cc1(0) and the supply of liquidity


RxC 4e c1 cc1 c1 0
is c 4e c1 . Late consumers will get a level of consumption c2 q
. Note
1c
that early consumers withdraw less than what is optimal, while late consumers withdraw
more than the optimal amount (that is, c2(q) > c2).


If the unexpected state occurs, early withdrawals are c 4e c1 0 and the total liquidity
is y q c 4e c1 , which is enough to assure the committed level of consumption to all

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99

early consumers (again because c1(0) < c1). Late consumers would get the amount
RxC c4e c1 c1 0
c2 q
. The banking system, with the intervention of the CB, avoids con1c4e
tagion since in t = 1 there is enough liquidity to face also the unexpected early consumers.
However, also in the unexpected state, consumption of early consumers is ineciently low
and late consumers consumption is higher than the level of constrained eciency (that is,
c2 q > c2 ).
With the more restricted notion of constrained-eciency, reserve requirements guarantee the sucient liquidity to avoid contagion and the CB does not need to declare the
insolvency of the banking system (reducing the promised consumption in t = 1). However,
the consumption levels dictated by constrained-eciency cannot be implemented. The reason is that, with non-contingent contract, reserve requirements have to be xed on top of
the normal commitment in t = 1, which implies that commercial banks do not internalize
the cost of the reserve and do not raise the inecient (low) amount of consumption promised to the early consumers. This makes it impossible to achieve constrained-eciency,
with early consumers penalized in favor of late consumers, but it still allows to invest in
the ecient portfolio (yC, xC) and to avoid crisis and contagion. Note that, even if the
CB cannot deliver the ecient consumption levels, no turmoil will occur since early consumers withdraw their promised amount c1(0) and incentive compatibility constraint for
late consumers always holds (since c1 0 < c1 6 c2 6 c2 < c2 q).
Since the incentive-ecient allocation analyzed in Section 3 guarantees an higher
expected utility than the constrained-ecient allocation analyzed in this section, the CB
should x reserve requirements letting banks to choose investment and consumption allocations and, in case of an unexpected shock, declare the insolvency of the banking system.
However, even if it is not possible to have such desirable ex-post exibility, xing reserve
requirements is still an eective instrument to avoid contagion.
7. Conclusion
The contribution of this paper is mainly normative, namely to analyze the role of a CB
in preventing nancial contagion. The CB nds its rationale on the bad distribution of
liquidity among dierent regions and on its dierent a-priori on the possible occurrence
of an aggregate shortage of liquidity. The CB, imposing reserve requirements on the
amount of deposits collected by commercial banks, is able to avoid contagion and to reach
rst-best allocation when contingent contracts are considered. If the analysis is restricted
to non-contingent contracts, the CB still avoids contagion without, however, reaching
rst-best consumption allocation.
Both the Diamond and Dybvig (1983) model and the one analyzed in this paper study
the optimal intervention of the CB in the presence of aggregate uncertainty. The distinction between the two models is that, while in the former the intervention of the CB takes
the form of deposit insurance that is enough to avoid the bad equilibrium (i.e., the bank
runs), in the latter the intervention of the CB needs to be more explicit through the imposition of reserve requirements.
The existence of contagion in Allen and Gale (2000) is related to the incomplete structure of the interbank deposit market. We show that contagion is not rooted in the
interbank deposit market, but in the impossibility for agents to sign contracts contingent
on unforeseen contingencies. Consequently, policy proposals that aim to improve the

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F. Castiglionesi / Journal of Banking & Finance 31 (2007) 81101

working of the nancial markets turn out to be necessary, but not sucient, measures in
order to deal successfully with nancial contagion. The presence of unforeseen contingencies is a form of market incompleteness. The CB then can be seen as a way to complete the
markets.
The present work nds a rationale for the presence of reserve requirements that is different from previous contributions. First, the CB intervention in our framework does not
rely on creation of liquidity. In order to prevent nancial contagion, the CB optimally xes
the liquidity that the banking system needs in the intermediate period. This implies that
holding reserves per se could be crucial, and not only a tool for stabilizing monetary policy. Second, in our model banks do not face asymmetric information problems, then regulatory intervention by means of reserve requirements does not derive from the fact that
banks activity is characterized by costly state verication. Third, the CB intervention does
not put any burden on taxpayer for bail out the distressed region.
The presence of reserve requirements has important implication for the welfare properties of the model. Using all the reserve requirements in case of an aggregate liquidity shock
implies that insolvency (or bankruptcy) involves no ex-post ineciency. From a theoretical point of view, also the existence of markets on which assets can be liquidated could
ensure ex-post eciency (resale prices would transfer value to the buyer but would not
constitute a deadweight loss). In our model, reserve requirements can be seen as a substitute for the missing markets on which is possible to liquidate the long asset. Without the
presence of these markets, eciency is reached by means of the imposition of reserve
requirements. The implication is that in a well developed market economy, where markets
for asset liquidation exist and are well functioning, the presence of reserve requirements
becomes less crucial. Our model predicts that the observed reduction of reserve requirements in well developed economies should not expose them to contagion. On the other
hand, in economies where nancial market are less developed, reducing reserve requirements would expose their systems to systemic risk.
From an historical point of view, nancial contagion cases have occurred mainly in the
US in the National Banking System period (18631913), and after the institution of
the Federal Reserve, which imposed reserve requirements, the frequency of nancial contagion is steadily decreased, as the model predicts. In the last decade, contagion phenomena aected mostly developing countries: South American countries after the Mexicos
crisis in 1994, or the SouthEast Asian countries after the crisis of Thailand in 1998. This
contagion eects usually followed processes of nancial liberalization, which implied
reduction on reserve requirements. If capital markets do not allow for liquidation of
long-term assets, then the model predicts that these economies are more exposed to
contagion.
Some caution is needed in interpreting our results. In particular, a very important concern in the debate on the opportunity to bail out distressed banks is the moral hazard
issue. Banks that know that there is the possibility to be bailed out by a CB in case of their
bankruptcy, have an incentive not to make the best eort in monitoring the investment
opportunities or can invest their resources in risky assets. In this study, the problem is
avoided altogether since the representative banks do not consider the possibility of an
aggregate liquidity shortage. This implies that banks do not expect to be bankrupt, and
consequently to be bailed out by the CB. This does not give any room for moral hazard
problem. A future research topic is to investigate the CB best policy given the trade-o
between reducing contagion and avoiding moral hazard problem.

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101

Acknowledgements
This paper is a slightly revised version of the rst chapter of my PhD dissertation at
Universidad Carlos III de Madrid. A special thank goes to Sandro Brusco who provided
invaluable feedback on each version of the paper. I am also indebted to Fabio Feriozzi,
Charles Goodharth, Guido Lorenzoni, Manuel Santos, an anonymous referee, seminar
participants at Universidad Carlos III, Universitat Auto`noma de Barcelona, XXVIII
Simposio de Analisis Economico, and XII Foro de Finanzas for useful comments. The
usual disclaimer applies.
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