Banks' Liquidity Provision and Panic Runs with Recursive Preferences

Abstract

How important is it to distinguish relative risk aversion (RRA) from the intertemporal elasticity of substitution (IES) to study banks' provision of liquidity insurance and the effectiveness of deposit freezes against depositors' panic runs? To answer these questions, I develop a Diamond-Dybvig model of banking in which depositors feature recursive preferences. In equilibrium, banks provide liquidity insurance, and a time-consistent deposit freeze prevents panic runs, only if depositors' preferences for an early resolution of uncertainty are sufficiently strong, i.e if RRA is sufficiently larger than the inverse of IES.

Keywords: financial intermediation, bank runs, recursive preferences, relative risk aversion, intertemporal elasticity of substitution

JEL Classification: D81, G21, G28