Economic Theory

, Volume 61, Issue 2, pp 335–363 | Cite as

Optimal banking contracts and financial fragility

  • Huberto M. Ennis
  • Todd Keister


We study a finite-depositor version of the Diamond–Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the constrained efficient allocation of resources in closed form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation resembles a standard bank deposit with a demandable debt-like structure. When withdrawals are unusually high, however, depositors who withdraw relatively late experience significant losses. This contractual arrangement can be fragile, admitting another equilibrium in which depositors run on the bank by withdrawing funds regardless of their liquidity needs.


Bank runs Demand deposits Sequential service  Liquidity insurance 

JEL Classification

G21 G01 D82 



We thank seminar participants at the European Central Bank, the IESE Business School, the University of Iowa, the Federal Reserve Banks of Philadelphia and Richmond, the 2010 Winter Meetings of the Econometric Society and the 2012 Meetings of the Society for Economic Dynamics for useful comments. We are especially grateful to Ed Green and Krishna B. Athreya for helpful discussions about some of the ideas in this paper. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of Richmond or the Federal Reserve System.


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Copyright information

© Springer-Verlag Berlin Heidelberg 2015

Authors and Affiliations

  1. 1.Research DepartmentFederal Reserve Bank of RichmondRichmondUSA
  2. 2.Department of EconomicsRutgers UniversityNew BrunswickUSA

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