Bank Panics and Scale Economies

29 Pages Posted: 30 Mar 2017 Last revised: 5 Jan 2019

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

Date Written: 2017-03-29

Abstract

A bank panic is an expectation-driven redemption event that results in a self-fulfilling prophecy of losses on demand deposits. From the standpoint of theory in the tradition of Diamond and Dybvig (1983) and Green and Lin (2003), it is surprisingly di¢ cult to generate bank panic equilibria if one allows for a plausible degree of contractual flexibility. A common assumption employed in the standard banking model is that returns are linear in the scale of investment. Instead, we assume the existence of a fixed investment cost, so that a higher risk-adjusted rate of return is available only if investment exceeds a minimum scale requirement. With this simple and empirically-plausible modification to the standard model, we find that bank panic equilibria emerge easily and naturally, even under highly flexible contractual arrangements. While bank panics can be eliminated through an appropriate policy, it is not always desirable to do so. We use our model to examine a number of issues, including the likely effectiveness of recent financial market regulations. Our model also lends some support for the claim that low-interest rate policy induces a “reach-for-yield” phenomenon resulting in a more panic-prone financial system.

JEL Classification: G01, G21, G28

Suggested Citation

Andolfatto, David and Nosal, Ed, Bank Panics and Scale Economies (2017-03-29). FRB St. Louis Working Paper No. 2017-9. Available at SSRN: https://ssrn.com/abstract=2943242 or http://dx.doi.org/10.20955/wp.2017.009

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)
604 291-5944 (Fax)

Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Ed Nosal

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

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

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
22
Abstract Views
188
PlumX Metrics