Demand Deposit Contracts and the Probability of Bank Runs

42 Pages Posted: 26 Feb 2002

See all articles by Itay Goldstein

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Ady Pauzner

Tel Aviv University - Eitan Berglas School of Economics

Date Written: February 2002

Abstract

We study a model of bank runs based on Diamond and Dybvig [1983]. We assume that agents do not have common knowledge regarding the fundamentals of the economy, but rather receive slightly noisy signals. The new model has a unique equilibrium in which the fundamentals determine whether a bank run will occur. This lets us compute the ex-ante probability of a bank run and relate it to the parameters of the demand deposit contract. We find that offering a higher return to agents who demand early withdrawal makes the bank more vulnerable to runs. We construct an optimal demand deposit contract that trades off the benefits from risk sharing against the costs of bank runs. Under this contract, there is a positive probability of panic-based bank runs. Nevertheless, it improves welfare relative to the autarkic regime. Finally, being able to make welfare computations, we assess the desirability of regimes that are intended to prevent bank runs: suspension of convertibility and deposit insurance.

Suggested Citation

Goldstein, Itay and Pauzner, Ady, Demand Deposit Contracts and the Probability of Bank Runs (February 2002). Available at SSRN: https://ssrn.com/abstract=301287 or http://dx.doi.org/10.2139/ssrn.301287

Itay Goldstein (Contact Author)

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

Ady Pauzner

Tel Aviv University - Eitan Berglas School of Economics ( email )

P.O. Box 39040
Ramat Aviv, Tel Aviv, 69978
Israel
972-3-640-9297 (Phone)
972-3-640-9908 (Fax)

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