Bank runs: Liquidity costs and investment distortions

Optimal Bank Regulation in the Presence of Credit and Run Risk

“…Or we could assume that it can be sold to some outside investors as in Shleifer and Vishny (1992). In other words, ξ does not strictly represent the salvage value of the long-term investment, as for example in Cooper and Ross (1998), but rather the liquidation/resale value of long-term investment. ξ has to be high enough that the bank can always withstand a panic for some realizations.…”

“…In the Diamond-Dybvig model panics are a multiple equilibrium outcome. Cooper and Ross (1998), Peck and Shell (2003) and Keister (2015) suppose instead that the probability of a bank-run is driven by sunspots. In our earlier working paper Kashyap, Tsomocos and Vardoulakis (2014), in Gertler and Kiyotaki (2015) and in Choi, Eisenbach and Yorulmazer (2016) the probability of a run is determined by an exogenous function of key fundamentals.…”

“…Absent constraints, the banker may want to offer an early deposit rate that is negative, since this would allow her to reduce the probability of a run. Such run-preventing deposit contracts have been studied for example in Cooper and Ross (1998). In our model, however, runnable deposits are important to discipline the banker and there are limits to how low the early deposit rate can be set both because of the disciplinary role and because savers can stop using the bank if the rates become too low.…”

“…This is not necessary when the liquidation value of long-term investment can be lower than one as pointed out by Cooper and Ross (1998). In addition, the share of income for the risky technology accruing to entrepreneurial human capital (set to 0.25) is chosen to reflect estimates from the literature.…”

“…A fair amount of literature has focused on run-proof equilibria, which naturally restrict credit intermediation (see Cooper and Ross, 1998, Ennis and Keister, 2006, Diamond and Kashyap. 2016).…”