BANK RUNS: Liquidity and Incentives
Diamond-Dybvig  provide a model of intermediation in which bank runs are driven by pessimistic depositor expectations. Models which address these issues are important in the ongoing discussion which weighs the costs (incentive problems) and the benefits (preventing runs) of deposit insurance. In the present paper we extend the Diamond-Dybvig analysis to consider several important questions for evaluating deposit insurance that could not be addressed within their framework. First, we provide conditions for runs when banks can invest in both illiquid and liquid projects. This results in a weakening of the conditions necessary for bank runs relative to the Diamond-Dybvig model in which no liquid investments occur in equilibrium. Second, we characterize how banks respond to the possibility of runs in their design of deposit contracts and investment decisions, particularly through the holding of excess reserves. Finally, we use this framework to evaluate the costs and benefits of deposit insurance and other forms of intervention. To do so, we introduce moral hazard and monitoring into the model to explore the incentive effects of deposit insurance. The implementation of a capital requirement can, along with deposit insurance, support the optimal allocation.
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- Douglas W. Diamond & Philip H. Dybvig, 2000.
"Bank runs, deposit insurance, and liquidity,"
Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
- Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
- V.V. Chari, 1989. "Banking without deposit insurance or bank panics: lessons from a model of the U.S. national banking system," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-19.
- Ma, Ching-To, 1988. "Unique Implementation of Incentive Contracts with Many Agents," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 555-72, October.
- Palfrey, Thomas R & Srivastava, Sanjay, 1987. "On Bayesian Implementable Allocations," Review of Economic Studies, Wiley Blackwell, vol. 54(2), pages 193-208, April.
- V.V. Chari & Ravi Jagannathan, 1984. "Banking Panics," Discussion Papers 618, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Postlewaite, Andrew & Vives, Xavier, 1987. "Bank Runs as an Equilibrium Phenomenon," Journal of Political Economy, University of Chicago Press, vol. 95(3), pages 485-91, June.
- Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
- Freeman, Scott, 1988. "Banking as the Provision of Liquidity," The Journal of Business, University of Chicago Press, vol. 61(1), pages 45-64, January.
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