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Optimal Reserves and Short Term Interest Rates in a Model of Bank Runs

  • Geethanjali Selvaretnam

    ()

Banks can fail because of bad economic fundamentals, and/or general panic withdrawals by depositors who feel the bank does not have sufficient reserves to meet the demand. This paper attempts to find the optimal reserve level and early returns the banks should decide on. If the reserve policy of the bank is transparent, it is found that more reserves have to be put aside over and above the real need, and this inefficiency increases with the proportion of impatient agents. It is also found that the optimal early return is lower than the first-best. The model recommends that when reserve policy is transparent there is no need for regulation. However, if reserve policy is not transparent, the model recommends regulation for both reserves and early returns. This is because of the moral hazard problem, the banks would keep lower reserves and offer higher early returns than what maximises depositor welfare.

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Paper provided by University of Essex, Department of Economics in its series Economics Discussion Papers with number 605.

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Date of creation: 15 Dec 2005
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Handle: RePEc:esx:essedp:605
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  1. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
  2. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
  3. Carlsson, H. & van Damme, E.E.C., 1990. "Global games and equilibrium selection," Discussion Paper 1990-52, Tilburg University, Center for Economic Research.
  4. S. Rao Aiyagari, 1988. "Banking panics, information, and rational expectations equilibrium," Working Papers 320, Federal Reserve Bank of Minneapolis.
  5. Morris, Stephen & Shin, Hyun Song, 1997. "Unique Equilibrium in a Model of Self-fulfilling Currency Attacks," CEPR Discussion Papers 1687, C.E.P.R. Discussion Papers.
  6. Bougheas, Spiros, 1999. "Contagious bank runs," International Review of Economics & Finance, Elsevier, vol. 8(2), pages 131-146, June.
  7. Alonso, Irasema, 1996. "On avoiding bank runs," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 73-87, February.
  8. Loewy, Michael B., 1998. "Information-Based Bank Runs in a Monetary Economy," Journal of Macroeconomics, Elsevier, vol. 20(4), pages 681-702, October.
  9. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  10. 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.
  11. Bhattacharya, S. & Boot, A.W.A. & Thakor, A.V., 1995. "The Economics of Bank Regulation," Papers 9516, Centro de Estudios Monetarios Y Financieros-.
  12. Stephen Morris & Hyun S Shin, 2001. "Global Games: Theory and Applications," Levine's Working Paper Archive 122247000000001080, David K. Levine.
  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. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  15. Cothren, Richard, 1987. "Asymmetric Information and Optimal Bank Reserves," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(1), pages 68-77, February.
  16. Williams, Joseph, 1988. " Banking Panics, Information, and Rational Expectations Equilibrium: Discussion," Journal of Finance, American Finance Association, vol. 43(3), pages 761-63, July.
  17. James Peck & Karl Shell, 2003. "Bank Portfolio Restrictions and Equilibrium Bank Runs," Levine's Bibliography 666156000000000077, UCLA Department of Economics.
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