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Bank Runs: Liquidity and Incentives

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  • Russell Cooper
  • Thomas W. Ross

Abstract

Diamond-Dybvig [1983] provide a model of intermediation in which bank runs are driven by pessimistic depositor expectations. Models which address these issues are important in the ongoing discussion which weighs the costs (incentive problems) and the benefits (preventing runs) of deposit insurance. In the present paper we extend the Diamond-Dybvig analysis to consider several important questions for evaluating deposit insurance that could not be addressed within their framework. First, we provide conditions for runs when banks can invest in both illiquid and liquid projects. This results in a weakening of the conditions necessary for bank runs relative to the Diamond-Dybvig model in which no liquid investments occur in equilibrium. Second, we characterize how banks respond to the possibility of runs in their design of deposit contracts and investment decisions, particularly through the holding of excess reserves. Finally, we use this framework to evaluate the costs and benefits of deposit insurance and other forms of intervention. To do so, we introduce moral hazard and monitoring into the model to explore the incentive effects of deposit insurance. The implementation of a capital requirement can, along with deposit insurance, support the optimal allocation.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3921.

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Date of creation: Nov 1991
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Publication status: Published as "Bank Runs: Liquidity Costs and Investment Distortions", Journal of Monetary Economics, Vol. 41, no. 1 (February 1998): 27-38.
Handle: RePEc:nbr:nberwo:3921

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  1. Freeman, Scott, 1988. "Banking as the Provision of Liquidity," The Journal of Business, University of Chicago Press, vol. 61(1), pages 45-64, January.
  2. V.V. Chari, 1989. "Banking without deposit insurance or bank panics: lessons from a model of the U.S. national banking system," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-19.
  3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  4. Postlewaite, Andrew & Vives, Xavier, 1987. "Bank Runs as an Equilibrium Phenomenon," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 95(3), pages 485-91, June.
  5. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  6. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, American Economic Association, vol. 81(3), pages 497-513, June.
  7. Ma, Ching-To, 1988. "Unique Implementation of Incentive Contracts with Many Agents," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 55(4), pages 555-72, October.
  8. Palfrey, Thomas R & Srivastava, Sanjay, 1987. "On Bayesian Implementable Allocations," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 54(2), pages 193-208, April.
  9. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
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Cited by:
  1. Todd Keister & Huberto M. Ennis, 2004. "Bank Runs and Investment Decisions Revisited," 2004 Meeting Papers 180, Society for Economic Dynamics.
  2. Haibin Zhu, 2000. "Optimal Bank Runs without Self-Fulfilling Prophecies," Econometric Society World Congress 2000 Contributed Papers 1753, Econometric Society.
  3. Lawrence Sáez & Xianwen Shi, 2004. "Liquidity Pools, Risk Sharing, and Financial Contagion," Journal of Financial Services Research, Springer, Springer, vol. 25(1), pages 5-23, February.
  4. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, Elsevier, vol. 41(1), pages 27-38, February.

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