Optimal banking contracts and financial fragility

Abstract

We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the constrained efficient allocation of resources in closed form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation resembles a standard bank deposit in that it has a demandable debt-like structure. When withdrawals are unusually high, however, depositors who withdraw relatively late experience significant losses. This contractual arrangement can be fragile, admitting another equilibrium in which depositors run on the bank by withdrawing funds regardless of their liquidity needs. JEL Classification Numbers: G21,G01, D82

Liquidity uncertainty and intermediation

“…For a review of the literature, see Gorton and Winton (2002). 4 See Cooper and Ross (1998), McCulloch and Yu (1998), Green and Lin (2003), Peck and Shell (2003), Andolfatto et al (2007), Ennis and Keister (2009), Nosal and Wallace (2009), and Ennis and Keister (2011). ting where consumers have corner preferences such that they consume only once in their lifetime, tradable equity contracts are welfare dominant as they provide consumers with optimal risk-sharing opportunities against idiosyncratic consumption shocks without the possibility of default. However, when preferences are assumed to be smooth over time such that different types of consumers have different valuation of consumption at different dates, the restriction that characterises the design of equity contracts which imposes the same wealth to consumers prior to trade in the secondary market, results in a welfare loss in comparison to tailor-made deposit contracts' allocations.…”

Sophisticated banking contracts and fragility when withdrawal information is public

“…In contrast, this paper assumes aggregate uncertainty , which is a more natural assumption with a finite number of depositors, and shows that multiple perfect Bayesian equilibria could exist in the full‐information withdrawal game. Ennis and Keister (2016) study a different setup in which only decisions of withdrawal are revealed to the bank and depositors. They show by examples that there are bank run equilibria under the optimal banking contract.…”

The effect of the central bank’s standing facilities on interbank lending and bank liquidity holding

“…(13) 16 Several possibilities to prevent bank runs are discussed by Ennis and Keister (2015) or Martin (2006), among others.…”