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Preventing bank runs

Author

Listed:
  • Andolfatto, David

    (Research Department, Federal Reserve Bank of St. Louis; Economics Department, Simon Fraser University;)

  • Nosal, Ed

    (Research Department, Federal Reserve Bank of Chicago)

  • Sultanum, Bruno

    (Research Department, Federal Reserve Bank of Richmond)

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.

Suggested Citation

  • Andolfatto, David & Nosal, Ed & Sultanum, Bruno, 2017. "Preventing bank runs," Theoretical Economics, Econometric Society, vol. 12(3), September.
    • Handle: RePEc:the:publsh:1970
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Bank runs; optimal deposit contract; financial fragility;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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