Date Added: Mar 2011
In this paper, the author analyzes how unobservable savings affect risk sharing and bankruptcy decisions in the financial system. The author extends the Diamond and Dybvig (1983) model of financial intermediation to an environment with heterogeneous intermediaries, aggregate uncertainty and agents' hidden borrowing and lending. The author demonstrates three results. First, unobservability imposes a burden on financial intermediaries, that in equilibrium are not able to offer a banking contract that balances insurance and incentive motivations. Second, unobservable markets do induce default, but only as long as insurance markets are incomplete. Third, even in case of complete markets the competitive equilibrium is inefficient, and a simple tier-1 capital ratio similar to the one proposed in the Basel III Accord implements the efficient allocation.