Liquidity Provision And Banking Crises With Heterogeneous Agents

The banking literature following Diamond and Dybvig [Journal of Political Economy 85, 191–206 (1983)] has assumed that all depositors are ex ante identical. This paper relaxes this assumption by introducing two types of agents. Whereas some agents are uncertain about their liquidity needs at the time they deposit in banks, other agents know exactly at what time they will want to withdraw their funds. Agents who know ex ante that they will want to withdraw in the short term will tend to disrupt the ability of a bank to serve customers who are uncertain about their timing of withdrawal. An adverse selection problem arises, where short-term deposits have the incentive to join the financial system and limit, or completely do away with, banks' liquidity provision service. On the other hand, potentially beneficial long-term funds will not be deposited in banks. Further, when unpredicted short-term withdrawal needs are sufficiently high, bank reserves are exhausted, and long-term investments need to be disrupted, causing a banking crisis.