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Time vs. Risk Preferences, Bank Liquidity Provision and Financial Fragility

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  • Ettore Panetti

Abstract

How important is it to distinguish relative risk aversion (RRA) from the intertemporal elasticity of substitution (IES) to understand bank liquidity provision and financial fragility? To answer this question, I develop a banking theory in which depositors feature Epstein-Zin preferences. In equilibrium, banks provide liquidity when RRA is sufficiently high (low) only for IES larger (smaller) than 1. Under the same conditions, banks might be fragile, i.e. subject to possible self-fulfilling depositors' runs. A time-consistent deposit freeze resolves banks' fragility if RRA is sufficiently low and IES is sufficiently larger than 1.

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  • Ettore Panetti, 2019. "Time vs. Risk Preferences, Bank Liquidity Provision and Financial Fragility," Working Papers w201917, Banco de Portugal, Economics and Research Department.
    • Handle: RePEc:ptu:wpaper:w201917
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    References listed on IDEAS

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    2. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-286, April.
    3. Attanasio, Orazio P & Weber, Guglielmo, 1989. "Intertemporal Substitution, Risk Aversion and the Euler Equation for Consumption," Economic Journal, Royal Economic Society, vol. 99(395), pages 59-73, Supplemen.
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