The Journal of Finance

Optimal Financial Crises

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00052

Franklin Allen, Douglas Gale

Empirical evidence suggests that banking panics are related to the business cycle and are not simply the result of “sunspots.” Panics occur when depositors perceive that the returns on bank assets are going to be unusually low. We develop a simple model of this. In this setting, bank runs can be first‐best efficient: they allow efficient risk sharing between early and late withdrawing depositors and they allow banks to hold efficient portfolios. However, if costly runs or markets for risky assets are introduced, central bank intervention of the right kind can lead to a Pareto improvement in welfare.

Rollover Risk and Market Freezes

Published: 07/19/2011   |   DOI: 10.1111/j.1540-6261.2011.01669.x

VIRAL V. ACHARYA, DOUGLAS GALE, TANJU YORULMAZER

The debt capacity of an asset is the maximum amount that can be borrowed using the asset as collateral. We model a sudden collapse in the debt capacity of good collateral. We assume short‐term debt that must be frequently rolled over, a small transaction cost of selling collateral in the event of default, and a small probability of meeting a buy‐to‐hold investor. We then show that a small change in the asset's fundamental value can be associated with a catastrophic drop in the debt capacity, the kind of market freeze observed during the crisis of 2007 to 2008.