Sunspot bank runs and fragility: The role of financial sector competition

What is the role of financial sector competition for instability when the potential for run behavior occurs with a non-trivial probability? How does the degree of fragility vary across competitive versus monopolistic banks? We study these questions in a version of the Diamond and Dybvig (1983) model of bank runs with limited commitment. In particular, we demonstrate that as the prospect of a run increases, competitive banks react prudently in issuing liabilities, leaving themselves less unstable. In contrast, if there is greater potential for consumer sentiment to deteriorate, agents’ incentives to run on monopolists are stronger over initially lower run probabilities but are weaker if crises are more likely to occur. Interestingly, the monopolist is only less susceptible to a panic over lower probabilities of crises while it is as fragile as its competitive counterpart in a more crisis-prone economy. Nevertheless, once bailouts are available, a higher run probability induces competitive banks to behave imprudently due to the incentive distortion. By comparison, agents’ inclination to run on monopolistic banks can either increase or decrease, depending on the structure of financial assistance. In addition, competitive intermediaries are more fragile if bailouts are large but this does not occur if fiscal transfers are small.