On the fundamental reasons for bank fragility

Economic Quarterly 01/2010;
Source: RePEc

ABSTRACT A substantial body of literature has now developed as a result of efforts to identify the fundamental reasons for the fragility of financial intermediaries in the Diamond-Dybvig theory of banking. Many of these articles focus on the interaction between sequential service and uncertainty about the aggregate need for liquidity in the economy. The articles in this literature are inevitably technical and focus somewhat narrowly on the implications of specific assumptions. Here, we provide a more accessible discussion of the main ideas and findings in this literature. Our discussion can be used as an introduction to the more technical articles or as an organizing framework for understanding the relative contribution of the main articles in this literature.

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    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 has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies. JEL Classification Numbers: G21,G01, D82 We thank seminar participants at the University of Iowa, the Federal Reserve Bank of Richmond, and 2010 Winter Meetings of the Econometric Society for useful comments. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve Bank of Richmond, or the Federal Reserve System.
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    ABSTRACT: The paper performs a welfare comparison between demand deposit and equity contracts in the presence of intrinsic aggregate uncertainty. In this framework, the welfare dominance of deposit contracts emerges under corner preferences. It is shown that aggregate uncertainty creates high price volatility of ex-dividend equity claims traded in a secondary market and the resulting consumption allocations offer less risk-sharing opportunities to risk-averse consumers than tailor-made deposit contracts. The contingency of early payoffs on depositors’ withdrawal order reinforces the welfare performance of deposit contracts, whereas costly liquidation of productive long-term investments deteriorates their welfare performance relative to equity contracts.
    Journal of Banking & Finance 02/2013; 37(2):403–414. DOI:10.1016/j.jbankfin.2012.09.026 · 1.29 Impact Factor
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    ABSTRACT: We study the Diamond-Dybvig model of financial intermediation (JPE, 1983) under theassumption that depositors have information about previous decisions. Depositors decidesequentially whether to withdraw their funds or continue holding them in the bank. If depositorsobserve the history of all previous decisions, we show that there are no bank runs in equilibriumindependently of whether the realized type vector selected by nature is of perfect or imperfectinformation.JEL classification numbers:
    SSRN Electronic Journal 01/2012; 15. DOI:10.1016/j.jfs.2014.09.004


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