IDEAS home Printed from https://ideas.repec.org/p/fip/fedrwp/15-06.html
   My bibliography  Save this paper

Optimal Banking Contracts and Financial Fragility

Author

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 in that it has a demand able 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.

Suggested Citation

  • Huberto M. Ennis & Todd Keister, 2015. "Optimal Banking Contracts and Financial Fragility," Working Paper 15-6, Federal Reserve Bank of Richmond.
  • Handle: RePEc:fip:fedrwp:15-06
    as

    Download full text from publisher

    File URL: https://www.richmondfed.org/-/media/richmondfedorg/publications/research/working_papers/2015/pdf/wp15-06.pdf
    File Function: Full text
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Green, Edward J. & Lin, Ping, 2003. "Implementing efficient allocations in a model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 109(1), pages 1-23, March.
    2. Azrieli, Yaron & Peck, James, 2012. "A bank runs model with a continuum of types," Journal of Economic Theory, Elsevier, vol. 147(5), pages 2040-2055.
    3. Todd Keister & Vijay Narasiman, 2016. "Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 89-104, July.
    4. Andolfatto, David & Nosal, Ed, 2008. "Bank incentives, contract design and bank runs," Journal of Economic Theory, Elsevier, vol. 142(1), pages 28-47, September.
    5. R. de O. Cavalcanti & P. K. Monteiro, 2016. "Enriching information to prevent bank runs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 477-494, August.
    6. Ennis, Huberto M. & Keister, Todd, 2006. "Bank runs and investment decisions revisited," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 217-232, March.
    7. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    8. Darrell, Duffie, 2010. "The Failure Mechanics of Dealer Banks," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 4, pages 131-153.
    9. Selgin, G., 1993. "In Defence of Bank Suspension," Papers 367, Georgia - College of Business Administration, Department of Economics.
    10. David Andolfatto & Ed Nosal & Bruno Sultanum, 2014. "Preventing bank runs," Working Papers 2014-21, Federal Reserve Bank of St. Louis.
    11. Dwyer, Gerald Jr. & Hasan, Iftekhar, 2007. "Suspension of payments, bank failures, and the nonbank public's losses," Journal of Monetary Economics, Elsevier, vol. 54(2), pages 565-580, March.
    12. Gu, Chao, 2011. "Noisy Sunspots And Bank Runs," Macroeconomic Dynamics, Cambridge University Press, vol. 15(3), pages 398-418, June.
    13. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867–1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1, January-J.
    14. Tanju Yorulmazer, 2014. "Case studies on disruptions during the crisis," Economic Policy Review, Federal Reserve Bank of New York, issue Feb, pages 17-28.
    15. Todd Keister, 2016. "Bailouts and Financial Fragility," Review of Economic Studies, Oxford University Press, vol. 83(2), pages 704-736.
    16. James Peck & Karl Shell, 2003. "Bank Portfolio Restrictions and Equilibrium Bank Runs," Levine's Bibliography 666156000000000077, UCLA Department of Economics.
    17. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
    18. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    19. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 12(Fall), pages 3-16.
    20. Jefferson Bertolai & Ricardo Cavalcanti & Paulo Monteiro, 2014. "Run theorems for low returns and large banks," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 57(2), pages 223-252, October.
    21. Gu, Chao, 2011. "Herding and bank runs," Journal of Economic Theory, Elsevier, vol. 146(1), pages 163-188, January.
    22. Neil Wallace, 1990. "A banking model in which partial suspension is best," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 14(Fall), pages 11-23.
    23. 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.
    24. Andolfatto, David & Nosal, Ed & Wallace, Neil, 2007. "The role of independence in the Green-Lin Diamond-Dybvig model," Journal of Economic Theory, Elsevier, vol. 137(1), pages 709-715, November.
    25. Ennis, Huberto M. & Keister, Todd, 2009. "Run equilibria in the Green-Lin model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1996-2020, September.
    26. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
    27. 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, vol. 24(Win), pages 3-13.
    28. Renee Courtois Haltom & Bruno Sultanum, 2018. "Preventing Bank Runs," Richmond Fed Economic Brief, Federal Reserve Bank of Richmond, issue March.
    29. Naohiko Baba & Robert N McCauley & Srichander Ramaswamy, 2009. "US dollar money market funds and non-US banks," BIS Quarterly Review, Bank for International Settlements, March.
    30. Patrick E. McCabe, 2010. "The cross section of money market fund risks and financial crises," Finance and Economics Discussion Series 2010-51, Board of Governors of the Federal Reserve System (U.S.).
    31. Sultanum, Bruno, 2014. "Optimal Diamond–Dybvig mechanism in large economies with aggregate uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 95-102.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Markus Kinateder & Hubert János Kiss & Ágnes Pintér, 2020. "Would depositors pay to show that they do not withdraw? Theory and experiment," Experimental Economics, Springer;Economic Science Association, vol. 23(3), pages 873-894, September.
    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. Kang, Minwook, 2020. "Demand deposit contracts and bank runs with present biased preferences," Journal of Banking & Finance, Elsevier, vol. 119(C).
    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.
    5. John Geanakoplos & Kieran James Walsh, 2018. "Inefficient liquidity provision," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 66(1), pages 213-233, July.
    6. Maria Näther, 2019. "The effect of the central bank’s standing facilities on interbank lending and bank liquidity holding," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 68(3), pages 537-577, October.
    7. 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.
    8. Sim, Khai Zhi, 2022. "The optimal bailout policy in an interbank network," Economics Letters, Elsevier, vol. 216(C).
    9. Markus Kinateder & Hubert Janos Kiss & Agnes Pinter, 2015. "Would depositors like to show others that they do not withdraw? Theory and Experiment," CERS-IE WORKING PAPERS 1553, Institute of Economics, Centre for Economic and Regional Studies.
    10. James Peck & Abolfazi Setayesh, . "Bank Runs and the Optimality of Limited Banking," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Li, Yang, 2017. "Interest rates and financial fragility," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 195-205.
    2. Gao, Jiahong & Reed, Robert R., 2021. "Sunspot bank runs and fragility: The role of financial sector competition," European Economic Review, Elsevier, vol. 139(C).
    3. Kučinskas, Simas, 2019. "Aggregate risk and efficiency of mutual funds," Journal of Banking & Finance, Elsevier, vol. 101(C), pages 1-11.
    4. Sultanum, Bruno, 2018. "Financial fragility and over-the-counter markets," Journal of Economic Theory, Elsevier, vol. 177(C), pages 616-658.
    5. Todd Keister & Vijay Narasiman, 2016. "Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 89-104, July.
    6. Kiss, Hubert Janos & Rodriguez-Lara, Ismael & Rosa-García, Alfonso, 2014. "Do social networks prevent or promote bank runs?," Journal of Economic Behavior & Organization, Elsevier, vol. 101(C), pages 87-99.
    7. J. D. P. Bertolai & R. de O. Cavalcanti & P. K. Monteiro, 2019. "Bank runs with many small banks and mutual guarantees at the terminal stage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 68(1), pages 125-176, July.
    8. Mitkov, Yuliyan, 2020. "Inequality and financial fragility," Journal of Monetary Economics, Elsevier, vol. 115(C), pages 233-248.
    9. Markus Kinateder & Hubert Janos Kiss & Agnes Pinter, 2015. "Would depositors like to show others that they do not withdraw? Theory and Experiment," CERS-IE WORKING PAPERS 1553, Institute of Economics, Centre for Economic and Regional Studies.
    10. Todd Keister, 2016. "Bailouts and Financial Fragility," Review of Economic Studies, Oxford University Press, vol. 83(2), pages 704-736.
    11. Kinateder, Markus & Kiss, Hubert János, 2014. "Sequential decisions in the Diamond–Dybvig banking model," Journal of Financial Stability, Elsevier, vol. 15(C), pages 149-160.
    12. Ennis, Huberto M. & Keister, Todd, 2009. "Run equilibria in the Green-Lin model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1996-2020, September.
    13. Todd Keister & Huberto M. Ennis, 2008. "Run Equilibria in a Model of Financial Intermediation," 2008 Meeting Papers 513, Society for Economic Dynamics.
    14. Kiss, Hubert János & Rodriguez-Lara, Ismael & Rosa-Garcia, Alfonso, 2022. "Who withdraws first? Line formation during bank runs," Journal of Banking & Finance, Elsevier, vol. 140(C).
    15. Zhiguo He & Asaf Manela, 2016. "Information Acquisition in Rumor‐Based Bank Runs," Journal of Finance, American Finance Association, vol. 71(3), pages 1113-1158, June.
    16. Bucher, Monika & Dietrich, Diemo & Tvede, Mich, 2018. "Coordination failures, bank runs and asset prices," Discussion Papers 39/2018, Deutsche Bundesbank.
    17. Jarrow, Robert & Xu, Liheng, 2015. "Bank runs and self-insured bank deposits," The Quarterly Review of Economics and Finance, Elsevier, vol. 58(C), pages 180-189.
    18. R. de O. Cavalcanti & P. K. Monteiro, 2016. "Enriching information to prevent bank runs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 477-494, August.
    19. Tarishi Matsuoka & Makoto Watanabe, 2017. "Banking Panics and Liquidity in a Monetary Economy," Tinbergen Institute Discussion Papers 17-091/VII, Tinbergen Institute.
    20. Ryuichiro Izumi, 2021. "Opacity: Insurance and Fragility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 40, pages 146-169, April.

    More about this item

    JEL classification:

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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedrwp:15-06. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: . General contact details of provider: https://edirc.repec.org/data/frbrius.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Pascasio (email available below). General contact details of provider: https://edirc.repec.org/data/frbrius.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.