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Federal Reserve Bank of Minneapolis Quarterly Review Vol. 24, No. 1, Winter 2000, pp. 14–23

Bank Runs, Deposit Insurance, and Liquidity
Douglas W. Diamond Theodore O. Yntema Professor of Finance Graduate School of Business University of Chicago Philip H. Dybvig Boatmen’s Bancshares Professor of Banking and Finance John M. Olin School of Business Washington University in St. Louis

AbstractThis article develops a model which 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 privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple 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 provision of deposit insurance can produce superior contracts. This article is reprinted from the Journal of Political Economy (June 1983, vol. 91, no. 3, pp. 401–19) with the permission ofthe University of Chicago Press.

The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

This article develops a model which 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 privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple 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 whengovernment provision of deposit insurance can produce superior contracts.

Bank runs are a common feature of the extreme crises that have played a prominent role in monetary history. During a bank run, depositors rush to withdraw their deposits because they expect the bank to fail. In fact, the sudden withdrawals can force the bank to liquidate many of its assets at a loss and to fail. During a panicwith many bank failures, there is a disruption of the monetary system and a reduction in production. Institutions in place since the Great Depression have successfully prevented bank runs in the United States since the 1930s. Nonetheless, current deregulation and the dire financial condition of savings and loan associations make bank runs and institutions to prevent them a current policy issue, asshown by recent aborted runs.1 (Internationally, Eurodollar deposits tend to be uninsured and are therefore subject to runs, and this is true in the United States as well for deposits above the insured amount.) It is good that deregulation will leave banking more competitive, but policymakers must ensure that banks will not be left vulnerable to runs. Through careful description and analysis,Friedman and Schwartz (1963) provide substantial insight into the properties of past bank runs in the United States. Existing theoretical analysis has neglected to explain why bank contracts are less stable than other types of financial contracts or to investigate the strategic decisions that depositors face. The model we present has an explicit economic role for banks to perform: the transformation ofilliquid claims (bank assets) into liquid claims (demand deposits). The analyses of Patinkin (1965, chap. 5), Tobin (1965), and Niehans (1978) provide insights into characterizing the liquidity of assets. This article gives the first explicit analysis of the demand for liquidity and the transformation service provided by banks. Uninsured demand deposit contracts are able to provide liquidity, but...
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