INTERMEDIATED VERSUS DIRECT-INVESTMENT - OPTIMAL LIQUIDITY PROVISION AND DYNAMIC INCENTIVE COMPATIBILITY

The existing banking literature leaves largely unanswered the question : what is the viability of bank liquidity provision if investors can d ynamically readjust their portfolios? To address this question, I anal yze the problem of optimal liquidity provision through bank deposit co ntracts in a simple continuous-time equilibrium model under uncertaint y. My model introduces the possibility of investors' directly investin g in the market, which gives rise to a moral hazard problem in the use of deposit contracts. I argue that this can severely restrict liquidi ty provision and characterizes incentive-compatible deposit contracts as second-best mechanisms to provide liquidity. The analysis shows tha t at the optimum, liquidity provision is negatively correlated with th e degree of irreversibility of the market investment opportunity. In p articular, when the market investment opportunity is completely revers ible, deposit contracts cannot provide any insurance against liquidity risks. (C) 1998 Academic Press.