Bank runs and investment decisions revisited
In this paper we extend the Cooper and Ross (1998) analysis of the optimal response of a competitive bank to the possibility of a bank run. If the probability of a run is small, the bank will offer a contract that admits a bank-run equilibrium. We show that, in this case, the bank will hold a quantity of liquid assets large enough to exactly meet withdrawal demand if a run does not occur; "excess" liquidity will not be held. This result allows us to determine how the possibility of a bank run affects the level of long-term investment chosen by a bank. We show that when the cost of liquidating investment early is high, the level of investment is decreasing in the probability of a run. However, when liquidation costs are smaller, the level of investment is actually increasing in the probability of a run.
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