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Optimal Financial Crises

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  • Franklin Allen
  • Douglas Gale

Abstract

Empirical evidence suggests that banking panics are a natural outgrowth of the business cycle. In other words panics are not simply the result of "sunspots" or self-fulfilling prophecies. Panics occur when depositors perceive that the returns on the bank's assets are going to be unusually low. In this paper we develop a simple model of this type of panic. In this setting bank runs can be incentive-efficient: they allow more efficient risk sharing between depositors who withdraw early and those who withdraw late and they allow banks to hold more efficient portfolios. Central bank intervention to eliminate panics can lower the welfare of depositors. However there is a role for the central bank to prevent costly liquidation of real assets by injecting money into the banking system during a panic.

Suggested Citation

  • Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  • Handle: RePEc:wop:pennin:97-01
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    File URL: http://fic.wharton.upenn.edu/fic/papers/97/9701.pdf
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    References listed on IDEAS

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    6. Waldo, Douglas G., 1985. "Bank runs, the deposit-currency ratio and the interest rate," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 269-277, May.
    7. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-276, June.
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