The Journal of Finance publishes leading research across all the major fields of finance. It is one of the most widely cited journals in academic finance, and in all of economics. Each of the six issues per year reaches over 8,000 academics, finance professionals, libraries, and government and financial institutions around the world. The journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics.
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Demand–Deposit Contracts and the Probability of Bank Runs
Published: 05/03/2005 | DOI: 10.1111/j.1540-6261.2005.00762.x
ITAY GOLDSTEIN, ADY PAUZNER
Diamond and Dybvig (1983) show that while demand–deposit contracts let banks provide liquidity, they expose them to panic‐based bank runs. However, their model does not provide tools to derive the probability of the bank‐run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic‐based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand–deposit contract that trades off the benefits from liquidity against the costs of runs.