Bank Runs: Liquidity and Incentives

46 Pages Posted: 27 Apr 2000 Last revised: 20 Sep 2010

See all articles by Russell Cooper

Russell Cooper

University of Texas at Austin - Department of Economics; National Bureau of Economic Research (NBER)

Thomas W. Ross

University of British Columbia (UBC) - Sauder School of Business

Date Written: November 1991

Abstract

Diamond-Dybvig [1983] provide a model of intermediation in which bank runs are driven by pessimistic depositor expectations. Models which address these issues are important in the ongoing discussion which weighs the costs (incentive problems) and the benefits (preventing runs) of deposit insurance. In the present paper we extend the Diamond-Dybvig analysis to consider several important questions for evaluating deposit insurance that could not be addressed within their framework. First, we provide conditions for runs when banks can invest in both illiquid and liquid projects. This results in a weakening of the conditions necessary for bank runs relative to the Diamond-Dybvig model in which no liquid investments occur in equilibrium. Second, we characterize how banks respond to the possibility of runs in their design of deposit contracts and investment decisions, particularly through the holding of excess reserves. Finally, we use this framework to evaluate the costs and benefits of deposit insurance and other forms of intervention. To do so, we introduce moral hazard and monitoring into the model to explore the incentive effects of deposit insurance. The implementation of a capital requirement can, along with deposit insurance, support the optimal allocation.

Suggested Citation

Cooper, Russell W. and Ross, Thomas, Bank Runs: Liquidity and Incentives (November 1991). NBER Working Paper No. w3921. Available at SSRN: https://ssrn.com/abstract=227375

Russell W. Cooper (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Thomas Ross

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
(604) 822-8500 (Phone)
(604) 822-8521 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
46
Abstract Views
1,451
PlumX Metrics