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Optimal banking contracts and financial fragility

  • Todd Keister

    (Federal Reserve Bank of New York)

  • Huberto Ennis

    (Richmond Fed)

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 has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 179.

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Date of creation: 2012
Date of revision:
Handle: RePEc:red:sed012:179
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  5. Gu, Chao, 2011. "Noisy Sunspots And Bank Runs," Macroeconomic Dynamics, Cambridge University Press, vol. 15(03), pages 398-418, June.
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  17. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
  18. 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.
  19. Todd Keister & Vijay Narasiman, . "Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
  20. Todd Keister, 2014. "Bailouts and Financial Fragility," Departmental Working Papers 201401, Rutgers University, Department of Economics.
  21. 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.
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  27. 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.
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