Economic Theory

, Volume 61, Issue 2, pp 335–363

Optimal banking contracts and financial fragility

Symposium

Abstract

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.

Keywords

Bank runs Demand deposits Sequential service  Liquidity insurance 

JEL Classification

G21 G01 D82 

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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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