Abstract
Diamond and Dybvig (1983) show that while demand-deposit contracts let banks provide liquidity, they expose them to panic-based bank runs. However, their model does not provide tools to derive the probability of the bank-run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic-based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand-deposit contract that trades off the benefits from liquidity against the costs of runs.
Original language | English |
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Pages (from-to) | 1293-1327 |
Number of pages | 35 |
Journal | Journal of Finance |
Volume | 60 |
Issue number | 3 |
DOIs | |
State | Published - Jun 2005 |