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Optimal banking contracts and financial fragility

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Author Info

  • Todd Keister

    (Federal Reserve Bank of New York)

  • Huberto Ennis

    (Richmond Fed)

Abstract

We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the (constrained) efficient allocation of resources in closed-form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 179.

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Date of creation: 2012
Date of revision:
Handle: RePEc:red:sed012:179

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References

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  1. Huberto M. Ennis & Todd Keister, 2004. "Bank runs and investment decisions revisited," Working Paper 04-03, Federal Reserve Bank of Richmond.
  2. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
  3. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  4. Edward J. Green & Ping Lin, 1996. "Implementing efficient allocations in a model of financial intermediation," Working Papers 576, Federal Reserve Bank of Minneapolis.
  5. Andolfatto, David, 2007. "Bank Incentives, Contract Design, and Bank Runs," MPRA Paper 8146, University Library of Munich, Germany.
  6. Gerald P. Dwyer, Jr. & Iftekhar Hasan, 1996. "Suspension of payments, bank failures, and the nonbank public's losses," Working Paper 96-3, Federal Reserve Bank of Atlanta.
  7. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
  8. Ennis, Huberto M. & Keister, Todd, 2009. "Run equilibria in the Green-Lin model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1996-2020, September.
  9. Gu, Chao, 2011. "Noisy Sunspots And Bank Runs," Macroeconomic Dynamics, Cambridge University Press, vol. 15(03), pages 398-418, June.
  10. Selgin, G., 1993. "In Defence of Bank Suspension," Papers 367, Georgia - College of Business Administration, Department of Economics.
  11. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867-1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1, May.
  12. David Andolfatto & Ed Nosal & Neil Wallace, 2006. "The role of independence in the Green-Lin Diamond-Dybvig model," Working Paper 0615, Federal Reserve Bank of Cleveland.
  13. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
  14. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
  15. Azrieli, Yaron & Peck, James, 2012. "A bank runs model with a continuum of types," Journal of Economic Theory, Elsevier, vol. 147(5), pages 2040-2055.
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Cited by:
  1. Markus Kinateder & Hubert Janos Kiss, 2013. "Sequential decisions in the Diamond-Dybvig banking model," IEHAS Discussion Papers 1345, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.

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