Bank Runs and Investment Decisions Revisited
24 Pages Posted: 5 Dec 2012 Last revised: 20 Feb 2013
Date Written: March 1, 2004
We examine how the possibility of a bank run affects the deposit contract offered and the investment decisions made by a competitive bank. Cooper and Ross (1998) have shown that when the probability of a run is small, the bank will offer a contract that admits a bank-run equilibrium. We show that, in this case, the bank will chose to hold an amount of liquid reserves exactly equal to what withdrawal demand will be if a run does not occur. In other words, precautionary or "excess" liquidity will not be held. This result allows us to determine how the possibility of a bank run affects the level of illiquid investment chosen by a bank. We show that when the cost of liquidating investment early is high, the level of investment is decreasing in the probability of a run. However, when liquidation costs are moderate, the level of investment is actually increasing in the probability of a run.
Keywords: bank runs, deposit contracts, bank reserves, sunspot equilibrium
JEL Classification: D84, E44, G21
Suggested Citation: Suggested Citation