135/2013 Marcus Miller and Lei Zhang
The classic Diamond-Dybvig model of banking assumes perfect competition and abstracts from issues of moral hazard, hardly appropriate when considering modern UK banking. We therefore modify the classic model to incorporate franchise values due to market power; and risk-taking by banks with limited liability. We go further to show how the capacity of franchise values to mitigate risk taking may be undermined by the bailout option; with explicit analytical results provided for the case of extreme risk-aversion. After a brief discussion of how this may impact on the distribution of income, we outline the ways in which the Vickers Report seeks to remedy these problems.
Culture and Development
Brussels Economic Review