Asset Prices and Bank Failures: Theory and Experimental Evidence

Abstract

In a Diamond--Dybvig framework with an interbank asset market, we study how regional liquidity shocks affect asset prices and bank stability. Banks face stochastic but offsetting liquidity needs and allocate deposits between cash and assets before shocks are realized, adjusting portfolios afterward. Theory predicts a fundamental equilibrium with stable asset prices and no bank failures. In an experiment, however, bankers over-allocate to cash, asset prices are inflated and volatile, and bank failures are frequent. We argue that equilibrium indeterminacy generates strategic uncertainty about other bankers' portfolio choices and the market-clearing price, limiting arbitrage and amplifying price distortions and instability.

Keywords: Asset prices, bank failures, strategic uncertainty, systemic fragility

JEL Classification: C92, D81, G21