Bank failures caused by large withdrawals: An explanation based purely on liquidity

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Abstract

In a version of the Diamond and Dybvig [Diamond, D., Dybvig, P., 1983. Bank runs, deposit insurance, and liquidity. Journal of Political Economy 91, 401–419.] model with aggregate uncertainty, we show that there exists an equilibrium with the following properties: all consumers deposit at the bank, all patient consumers wait for the last period to withdraw, and the bank fails with strictly positive probability. Furthermore, we show that the probability of a bank failure remains bounded away from zero as the number of consumers increases.

This equilibrium explains bank failures driven by extreme withdrawals solely on liquidity since they happen because both banks and depositors are illiquid. Furthermore, it does not require much of the elements typically emphasized, including: consumers well informed about the true state of nature, a non-zero consumption after a crisis, consumers’ panic and sunspots. We therefore think that aggregate risk in Diamond-Dybvig-like environments can be an important element to explain bank crises.
Original languageEnglish
Pages (from-to)818-841
JournalJournal of Mathematical Economics
Volume43
Issue number7-8
DOIs
Publication statusPublished - 1 Jan 2007

Keywords

  • Bank crises
  • Aggregate uncertainty
  • Liquidity

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