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The Effect of Safe Assets on Financial Fragility in a Bank-Run Model

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  • Toni Ahnert
  • Mahmoud Elamin

Abstract

Risk-averse investors induce competitive intermediaries to hold safe assets, thereby lowering the probability of a run and reducing financial fragility. We revisit Goldstein and Pauzner (2005), who obtain a unique equilibrium in the banking model of Diamond and Dybvig (1983) by introducing risky investment and noisy private signals. We show that, in the optimal demand-deposit contract subject to sequential service, banks hold safe assets to insure investors against investment risk. Consequently, fewer investors withdraw prematurely, which reduces the probability of a bank run. Safe asset holdings increase investor welfare and may increase the bank?s provision of liquidity.

Suggested Citation

  • Toni Ahnert & Mahmoud Elamin, 2014. "The Effect of Safe Assets on Financial Fragility in a Bank-Run Model," Working Papers (Old Series) 1437, Federal Reserve Bank of Cleveland.
    • Handle: RePEc:fip:fedcwp:1437
    DOI: 10.26509/frbc-wp-201437
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    References listed on IDEAS

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    4. Timmermann, Allan & Wermers, Russ, 2014. "Runs on Money Market Funds," CEPR Discussion Papers 9906, C.E.P.R. Discussion Papers.
    5. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    6. Itay Goldstein & Ady Pauzner, 2005. "Demand–Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, June.
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    10. Mahmoud Elamin, 2013. "On the non-optimality of a Diamond-Dybvig contract in the Goldstein-Pauzner environment," Working Papers (Old Series) 1306, Federal Reserve Bank of Cleveland.
    11. Marcin Kacperczyk & Philipp Schnabl, 2013. "How Safe Are Money Market Funds?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 128(3), pages 1073-1122.
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    Cited by:

    1. Allen, Franklin & Carletti, Elena & Goldstein, Itay & Leonello, Agnese, 2018. "Government guarantees and financial stability," Journal of Economic Theory, Elsevier, vol. 177(C), pages 518-557.
    2. E. Panetti & LG Deidda, 2018. "Banks' Liquidity Management and Financial Fragility," Working Paper CRENoS 201809, Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia.
    3. E. Panetti & LG Deidda, 2017. "Banks' Liquidity Management and Systemic Risk," Working Paper CRENoS 201705, Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia.

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    More about this item

    Keywords

    bank runs; demand deposits; global games; liquidity provision; safe assets;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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