Preventing Bank Runs

FRB of St. Louis Working Paper No. 2014-021A

20 Pages Posted: 2 Aug 2014

See all articles by David Andolfatto

David Andolfatto

Simon Fraser University (SFU) - Department of Economics; Federal Reserve Bank of St. Louis

Ed Nosal

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Bruno Sultanum

Federal Reserve Banks - Federal Reserve Bank of Richmond

Multiple version iconThere are 2 versions of this paper

Date Written: July 31, 2014

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.

JEL Classification: D82, E58, G21.

Suggested Citation

Andolfatto, David and Nosal, Ed and Sultanum, Bruno, Preventing Bank Runs (July 31, 2014). FRB of St. Louis Working Paper No. 2014-021A. Available at SSRN: https://ssrn.com/abstract=2474839 or http://dx.doi.org/10.2139/ssrn.2474839

David Andolfatto (Contact Author)

Simon Fraser University (SFU) - Department of Economics ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada
604 291-5825 (Phone)
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Federal Reserve Bank of St. Louis ( email )

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United States

Ed Nosal

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Bruno Sultanum

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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