Optimal Financial Crises

97-01

Posted: 25 Feb 1997

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Douglas M. Gale

New York University (NYU) - Department of Economics

Date Written: December 1996

Abstract

Empirical evidence suggests that banking panics are a natural outgrowth of the business cycle. In other words panics are not simply the result of "sunspots" or self-fulfilling prophecies. Panics occur when depositors perceive that the returns on the bank's assets are going to be unusually low. In this paper we develop a simple model of this type of panic. In this setting bank runs can be incentive-efficient: they allow more efficient risk sharing between depositors who withdraw early and those who withdraw late and they allow banks to hold more efficient portfolios. Central bank intervention to eliminate panics can lower the welfare of depositors. However there is a role for the central bank to prevent costly liquidation of real assets by injecting money into the banking system during a panic.

JEL Classification: E32, E42, E58, G21, G28

Suggested Citation

Allen, Franklin and Gale, Douglas M., Optimal Financial Crises (December 1996). 97-01. Available at SSRN: https://ssrn.com/abstract=8132

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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