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Optimal banking contracts and financial fragility

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  • Huberto Ennis

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  • Todd Keister

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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 resembles a standard bank deposit with a demandable debt-like structure. When withdrawals are unusually high, however, depositors who withdraw relatively late experience significant losses. This contractual arrangement can be fragile, admitting another equilibrium in which depositors run on the bank by withdrawing funds regardless of their liquidity needs. Copyright Springer-Verlag Berlin Heidelberg 2016

Suggested Citation

  • Huberto Ennis & Todd Keister, 2016. "Optimal banking contracts and financial fragility," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 61(2), pages 335-363, February.
  • Handle: RePEc:spr:joecth:v:61:y:2016:i:2:p:335-363
    DOI: 10.1007/s00199-015-0899-2
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    Cited by:

    1. Markus Kinateder & Hubert Janos Kiss & Agnes Pinter, 2015. "Would depositors like to show others that they do not withdraw? Theory and Experiment," IEHAS Discussion Papers 1553, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
    2. Douglas D. Davis & Robert J. Reilly, 2016. "On Freezing Depositor Funds at Financially Distressed Banks: An Experimental Analysis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(5), pages 989-1017, August.
    3. Jianjun Miao, 2016. "Introduction to the symposium on bubbles, multiple equilibria, and economic activities," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 61(2), pages 207-214, February.
    4. James C. D. Fisher & John Wooders, 2017. "Interacting information cascades: on the movement of conventions between groups," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 63(1), pages 211-231, January.

    More about this item

    Keywords

    Bank runs; Demand deposits; Sequential service ; Liquidity insurance; G21; G01; D82;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G01 - Financial Economics - - General - - - Financial Crises
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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