Bank Panics with Scale Economies

David Andolfatto (dxa1048@miami.edu)

No 265, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: A bank panic is an expectation-driven mass redemption event that results in a self-fulfilling prophecy of losses on demand deposits. We replace sequential service in the Green and Lin (2003) version of the Diamond and Dybvig (1983) model with scale economies in investment opportunities: higher risk-adjusted returns are available for investments that require larger fixed costs. We demonstrate how scale economies and private information are both necessary to generate a bank panic equilibrium. Floating net asset valuation methods---which recent regulations have imposed on some money mutual funds---do not eliminate panics. However, restrictions that resemble redemption gates and fees---also imposed on some money mutual funds---can eliminate panics, albeit at the cost of reduced risk-sharing. The expected cost of eliminating panics, however, falls as banks become larger or more interconnected. Finally, we discuss how our theory is consistent with the notion that a low-interest rate policy induces a reach-for-yield behavior that potentially manifests itself as a less stable financial system.

Date: 2017
New Economics Papers: this item is included in nep-ban
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:265

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