Bank Runs, Deposit Insurance, and Liquidity

TLDR

Investors face privately observed risks that create a demand for liquidity, and traditional demand deposit contracts can have multiple equilibria, including a bank run. The article develops a model showing that bank deposit contracts can yield allocations superior to exchange markets, explaining how banks facing runs can attract deposits. The authors study contracts that can prevent runs and find that, under certain circumstances, government-provided deposit insurance can produce superior contracts. The model shows that bank deposit contracts can yield allocations superior to exchange markets, that bank runs cause real economic damage, and that government-provided deposit insurance can produce superior contracts that prevent runs.

Abstract

This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.