NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Bank Runs: Liquidity and Incentives

Russell Cooper, Thomas W. Ross

NBER Working Paper No. 3921
Issued in November 1991
NBER Program(s):   EFG

Diamond-Dybvig [1983] provide a model of intermediation in which bank runs are driven by pessimistic depositor expectations. Models which address these issues are important in the ongoing discussion which weighs the costs (incentive problems) and the benefits (preventing runs) of deposit insurance. In the present paper we extend the Diamond-Dybvig analysis to consider several important questions for evaluating deposit insurance that could not be addressed within their framework. First, we provide conditions for runs when banks can invest in both illiquid and liquid projects. This results in a weakening of the conditions necessary for bank runs relative to the Diamond-Dybvig model in which no liquid investments occur in equilibrium. Second, we characterize how banks respond to the possibility of runs in their design of deposit contracts and investment decisions, particularly through the holding of excess reserves. Finally, we use this framework to evaluate the costs and benefits of deposit insurance and other forms of intervention. To do so, we introduce moral hazard and monitoring into the model to explore the incentive effects of deposit insurance. The implementation of a capital requirement can, along with deposit insurance, support the optimal allocation.

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Document Object Identifier (DOI): 10.3386/w3921

Published: Published as "Bank Runs: Liquidity Costs and Investment Distortions", Journal of Monetary Economics, Vol. 41, no. 1 (February 1998): 27-38.

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