Bank Runs, Deposit Insurance, and Liquidity

Abstract

This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face pri- vately observed risks which lead to a demand for liquidity. Tradi- tional demand deposit contracts which provide liquidity have multi- ple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provi- sion of deposit insurance can produce superior contracts.