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Preventing bank runs

David Andolfatto (), Ed Nosal and Bruno Sultanum

No 2014-21, Working Papers from Federal Reserve Bank of St. Louis

Abstract: Diamond and Dybvig (1983) is commonly understood as providing a formal rationale for the existence of bank-run equilibria. It has never been clear, however, whether bank-run equilibria in this framework are a natural byproduct of the economic environment or an artifact of suboptimal contractual arrangements. In the class of direct mechanisms, Peck and Shell (2003) demonstrate that bank-run equilibria can exist under an optimal contractual arrangement. The difficulty of preventing runs within this class of mechanism is that banks cannot identify whether withdrawals are being driven by psychology or by fundamentals. Our solution to this problem is an indirect mechanism with the following two properties. First, it provides depositors an incentive to communicate whether they believe a run is on or not. Second, the mechanism threatens a suspension of convertibility conditional on what is revealed in these communications. Together, these two properties can eliminate the prospect of bank-run equilibria in the Diamond-Dybvig environment.

Keywords: bank runs; optimal deposit contract; financial fragility (search for similar items in EconPapers)
JEL-codes: D82 E58 G21 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2014-08-04
New Economics Papers: this item is included in nep-ban, nep-mac and nep-mic
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Citations: View citations in EconPapers (18)

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Journal Article: Preventing Bank Runs (2018) Downloads
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Working Paper: Preventing Bank Runs (2014) Downloads
Working Paper: Equilibrium Bank Runs Revisied (2014) Downloads
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