Liquidity Coinsurance, Moral Hazard, and Financial Contagion




    Search for more papers by this author
    • Sandro Brusco is at the Department of Economics, Stony Brook University; Fabio Castiglionesi is at CentER, Finance Department, Tilburg University. The first version of this paper appeared as a chapter of Castiglionesi's PhD dissertation at Universidad Carlos III de Madrid. We would like to thank Michele Boldrin, Giovanni Cespa, Guido Lorenzoni, Ignacio Peña, Margarita Samartín, Georges Siotis, Branko Urosevic, and seminar participants at Universitat Autónoma de Barcelona, XII Foro de Finanzas, Universidad Carlos III, and the CFS Conference at Goethe University Frankfurt for useful comments.


We study the propagation of financial crises among regions in which banks are protected by limited liability and may take excessive risk. The regions are affected by negatively correlated liquidity shocks, so liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky a limited amount of capital is sufficient to prevent risk-taking, but when financial markets are open capital becomes insufficient. Thus, bankruptcy occurs with positive probability and the crisis spreads to other regions via financial linkages. Opening financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk-taking.