Demand-deposit contracts and the probability of bank runs

Itay Goldstein*, Ady Pauzner

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

396 Scopus citations

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 languageEnglish
Pages (from-to)1293-1327
Number of pages35
JournalJournal of Finance
Volume60
Issue number3
DOIs
StatePublished - Jun 2005

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