Optimal Bank Regulation In the Presence of Credit and Run-Risk

We modify the Diamond and Dybvig (1983) model so that, besides offering liquidity services to depositors, banks also raise equity funding, make loans that are risky, and can invest in safe, liquid assets. The bank and its borrowers are subject to limited liability. When profitable, banks monitor borrowers to ensure that they repay loans. Depositors may choose to run based on conjectures about the available resources for people withdrawing early and beliefs about banks’ monitoring. We model the run decision by solving a novel global game. We find that banks opt for a more deposit-intensive capital structure than a social planner would choose. The privately chosen asset portfolio can be more or less lending-intensive, while the level of lending can also be higher or lower depending on a planner’s preferences between liquidity provision and credit extension. To correct these three distortions, a package of three regulations is warranted.