Bank Runs, Deposit Insurance, and Liquidity

Abstract

This publication primarily presents economic research ai med at improving policymaking by the Federal Reserve System and other governmental authorities.

Predatory Short Selling

“…This contrasts with the situation that would arise if short sellers were regular sellers: While a setup with regular sellers instead of short sellers would lead to the same two equilibria in the vulnerability region, regular sellers strictly prefer the equilibrium in which they hold on to their shares and do not sell. Hence, with regular sellers, the dominated equilibrium can emerge only as a result of coordination failure-existing shareholders sell because they expect everyone else to sell, comparable to the dominated equilibrium in Diamond and Dybvig (1983). While this, of course, does not rule out the dominated equilibrium, it is a reasonable proposition that the dominated equilibrium is less likely to emerge through a pure coordination failure of regular sellers than through a (weakly) profitable attack by predatory short sellers.…”

“…Specifically, relative to corporations that can match maturities of assets and liabilities, the business model of a financial institution almost necessarily involves maturity and liquidity mismatch (see, e.g., Diamond and Dybvig (1983) and Brunnermeier, Gorton, and Krishnamurthy (2013)). Moreover, beyond the maturity mismatch that is inherent in their business model, financial institutions may have an additional incentive to take on significant maturity mismatch because of collective moral hazard (Farhi and Tirole (2012)) or because their inability to commit to longer-term financing leads to a maturity rat race (Brunnermeier and Oehmke (2013)).…”

“…In particular, if current shareholders fear that other shareholders are likely to sell their holdings, such panic sales can become self-fulfilling for financial institutions that are subject to leverage constraints of the type described in our model. Hence, akin to the classic bank run problem described in Diamond and Dybvig (1983), our analysis implies that regulators may want to watch for runs on the equity of financial institutions that are subject to leverage constraints. As shown in Proposition 3, this concern is stronger the less likely it is that current shareholders can coordinate their actions.…”

“…Predatory short selling can occur in our model because financial institutions are subject to leverage constraints imposed by their short-term creditors and uninsured depositors. These leverage constraints capture a first-order difference between financial institutions and regular corporates: Relative to corporations that can match maturities of assets and liabilities, the business model of a financial institution almost necessarily involves maturity and liquidity mismatch (see, e.g., Diamond and Dybvig (1983) and Brunnermeier, Gorton, and Krishnamurthy (2013)), which exposes financial institutions to sudden withdrawal of funding in response to declines in equity value. We show that, in the presence of such leverage constraints, predatory short sellers that temporarily depress the stock price of a financial institution can force the financial institution to sell long-term assets in order to repay debt to satisfy their leverage constraint.…”

Credit Risk Spillovers, Systemic Importance and Vulnerability in Financial Networks

“…2 One of the first models studying financial contagion on networks is Allen & Gale (2000). The authors extend Diamond & Dybvig (1983) to a four banks system, showing how the completeness and distribution of interconnections determine the extent of spillovers following a bank-specific shock. With evenly allocated deposits, contagion may be completely avoided, whereas in an incomplete system, a cascade of failures might emerge.…”