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Equilibrium Non-Panic Bank Failures

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  • Carmona, Guilherme
  • Leoni, Patrick
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    Abstract

    We observe many episodes in which a large number of people attempt to withdraw their deposits from a bank, forcing it to suspend withdrawals or even to fail. In contrast with the view that those episodes are driven by consumers panic or sunspots, we propose to explain them as a consequence of the conjunction of lack of full back up of deposits by banks, and of an unexpectedly high fraction of withdrawers. We validate this view in a version of the standard Diamond and Dybvig [8] model, in which the fraction of impatient consumers is drawn stochastically according to a continuous density function, by showing that: (1) when banks are not allowed to suspend payments, in every symmetric equilibrium where agents deposit banks fail with strictly positive probability, and (2) in every such equilibrium, failure occurs whereas patient consumers find it optimal not to withdraw early. Moreover, we obtain similar results when banks are allowed to suspend payments, and we show that consumers ex-ante welfare is strictly higher compared to when banks cannot suspend payments. Our contribution is therefore two-fold: (1) bank failures driven by large withdrawals can be explained by any fundamental shock that leads to an high fraction of withdrawers, and (2) suspension of payments might be a critical part of the protection of the banking system.

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    File URL: http://fesrvsd.fe.unl.pt/WPFEUNL/WP2003/wp424.pdf
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    Bibliographic Info

    Paper provided by Universidade Nova de Lisboa, Faculdade de Economia in its series FEUNL Working Paper Series with number wp424.

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    Length: 29 pages
    Date of creation: 2003
    Date of revision:
    Handle: RePEc:unl:unlfep:wp424

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    1. Edward J. Green, 1995. "Implementing Efficient Allocations in a Model of Financial Intermediation," Meeting papers 9506001, EconWPA.
    2. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 11-23.
    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. Chari, V V & Jagannathan, Ravi, 1988. " Banking Panics, Information, and Rational Expectations Equilibrium," Journal of Finance, American Finance Association, vol. 43(3), pages 749-61, July.
    5. S. Rao Aiyagari, 1988. "Banking panics, information, and rational expectations equilibrium," Working Papers 320, Federal Reserve Bank of Minneapolis.
    6. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
    7. Ted Temzelides & Bernandino Adao, 1995. "Beliefs, Competition, and Bank Runs," Finance 9511001, EconWPA.
    8. Edward J. Green & Ping Lin, 2000. "Diamond and Dybvig's classic theory of financial intermediation : what's missing?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-13.
    9. Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 568-92, June.
    10. Guilherme Carmona, 2003. "Monetary trading: An Optimal Exchange System," Game Theory and Information 0309004, EconWPA.
    11. Postlewaite, Andrew & Vives, Xavier, 1987. "Bank Runs as an Equilibrium Phenomenon," Journal of Political Economy, University of Chicago Press, vol. 95(3), pages 485-91, June.
    12. V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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