Financial Fragility in Monetary Economies

We integrate the Diamond and Dybvig (1983) theory of financial fragility with the Lagos and Wright (2005) model of monetary exchange. Non-bank monetary economies with well-functioning secondary markets for capital can allocate risk reasonably well, but are never efficient. When secondary markets are subject to ``market freeze'' events, risk-sharing deteriorates accordingly. A fractional-reserve bank can dominate a monetary economy because: (i) it provides superior risk-sharing even when market freeze events are absent; and (ii) it bypasses the need for a secondary capital market to begin with. Indeed, fractional reserve banks can implement the optimal allocation when monetary policy follows the Friedman rule. However, the desirability of fractional reserve banking is diminished if the structure is subject to ``bank runs''. In the event of a run, an open secondary market allows banks to liquidate capital at a price that permits honoring all deposit obligations. If bank runs are expected to occur with a sufficiently high probability, then a narrow banking structure may be preferred. Narrow banks are more stable, but offer less risk-sharing. We find that high inflation economies penalize narrow banking systems relatively more than fractional reserve systems. Special interests are not generally aligned over the choice of bank regime.