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Merwan ENGINEER*
Unr~wrsr~v of Guelph, Guelph, 0n1 Canadu NIG -7WI
1. Introduction
*I am grateful to Dave Backus, Dan Bemhardt, Michael Hoy. Dave Nickerson. Dan Peled, and
an anonymous referee for their very helpful comments.
’ For drfferent perspecttves on the suspensron of convertibility see Gorton (1985) and Char-i and
Jagannathan (1988).
“The reasons for a bank run in this model are quite different from those of Postlewaite and
Vives (1987) who also develop a four-period banking model. They model the strategic game
between two depositors, both of whom discover their type in period 1. If both agents turn out to
be type 2 agents a Prisoner’s Dilemma arises where each has a donunant strategy to withdraw in
period 1. This bank run occurs not because agents condition their behavior on an exogenous
sunspot but because aggregate preferences are uncertain.
In Bryant (1980) Chari and Jagannathan (1988). and Jacklin and Bhattacharya (1988) bank
runs occur because depositors receive information about the banks asset returns in the interim
penod. In Diamond and Dybvig and this paper bank runs occur in the absence of private
information about asset returns.
M. Engmeer. Bunk runs and the suspensron of deposit convertrhilq 445
ences over time is in the spirit of the banking analysis based on agents having
unknown liquidity demands.
A policy where the bank can freely liquidate assets and alter payments after
observing too many withdrawals in period 1 is also analyzed. The policy
involves offering a follow-up payment in period 1 that is attractive only to type
1 agents. If the remaining type 1 agents can be served cheaply in this way a
run is prevented. However, if type 1 agents value period 2 consumption
sufficiently highly, the follow-up payment must be large and bank runs cannot
be prevented.
The paper proceeds as follows. The model is outlined in section 2 and the
optimal risk sharing allocation is described in section 3. Section 4 briefly
analyzes the equilibria under the standard demand deposit contract. Section 5
demonstrates that the immediate suspension of convertibility does not elimi-
nate bank runs. A flexible payment policy designed to prevent bank runs is
developed in section 6. Finally, other institutions such as deposit insurance
and the exchange of dividend-paying shares are briefly examined in section 7.
2. The model
Gpe 1
Type 3
where t’, t’, and t3 = (1 - t’ - t2) are the known proportions of type 1, 2, and
3 agents. Agent type is private information. In period 1, type 1 agents discover
their type and types 2 and 3 learn they are nontype 1 agents; in period 2, type
2 and 3 agents discover their specific type. Unlike in the three-period model,
all agents do not discover their type at the same time.
3Dlamond and Dybvig do not explicitly model type 1 agents valuing penod 2 consumption. In
Wallace (1988) agents have a constant marginal rate of substitution in consumption between
periods much hke above.
M Engtneer, Bank runs and the suspensron of deposit concertdxlq 447
The bank invests its deposits to achieve the optimal allocation. Under the
standard demand deposit contract, the bank promises to pay out cT = xF* to
any agent withdrawing his entire deposit in period T = 1,2. Agents that
attempt to withdraw in a particular period arrive in the bank line in random
order and are served sequentially. If the bank faces a shortage of funds to
service withdrawals in either period 1 or 2, it allocates on a first come, first
serve basis. In this case some demanders are left with nothing in the period
that they most want to consume. In the last period the bank is liquidated and
the remaining depositors receive their pro rata share of any remaining assets.4
The efficient bank equilibrium emerges when all active deposit holders
believe that other agents intend to withdraw their deposits only in the period
that they most want to consume, ck = x;* for T = i and ck = 0 for T # i. With
these beliefs, the best response of any agent is to withdraw his deposit in the
period which he most wants to consume. At no stage does the bank have to
prematurely liquidate productive assets to service withdrawal demands.
There also is a Pareto-inferior bank-run equilibrium. Suppose all agents in
period 1 believe that other investors are going to attempt to withdraw in
period 1. If an investor attempts to withdraw his deposit, he is successful with
probability ( CX: + cy:S, + cu:L,)/x:* < 1. On the other hand, if he does not
attempt to withdraw his money, all of the bank’s assets are liquidated and
distributed in period 1 leaving him with nothing. For this reason all deposit
holders participate in the bank run when they believe others also are going to
run.
4Bank runs are harder to avert if the bank contract ts c-I = xF* to any agent who wtthdraws hts
deposit m period i- = 1.2.3 as long as funds last.
‘In the three-penod model, declaring bankruptcy to prevent the value destroymg sale of assets
in period 1, with the legal proceedings m period 2, has the same effect as tmmediately suspending
convertibility and, therefore, also averts a run Note that wrth completely illiqmd assets. the bank
has no chorce but to declare bankruptcy when faced with too many withdrawals m period 1 Thus,
the three-period model suggests paradoxtcally that banks, if they have the choice, should Invest m
completely illiqmd rather than liquid assets to precommit and avoid the bad equilibnum.
448 M. Engineer, Bank runs and the swpens~on of deposrt conuertlbdq
(t” + pt3)
PU( x:*> ’ 2,
1 - t’
where
tlt3
u(x22*) + mP+,zx:*)
+ &JPMX:.)I.
The equilibrium is characterized by all agents queuing for withdrawals in period 1
and the following rationed proportions of agents of each type withdrawing
c$ = XT’* in period T:
Period ( T)
Type (i> 1 2 3
2 et2
(t’)’ t’t2t3
l-t3 l-t3
t*
yqy+4*) =“f’:f3’
+ -&p)*u(x;*) p+:*>
of each type receive xi‘* , leaving 1 - t’ of each type with remaining claims
under the bank-run scenario. In period 2, type 2 and 3 agents discover their
type. Now the remaining type 1 and 2 agents have a dominant strategy to
queue in period 2. Together they constitute the proportion (t’ + t’)(l - rl) =
t2 + t’t3 of the population. The bank distributes xi* to t2 agents in period 2,
bumping the remaining t1t3 agents to period 3. Since there is no excess
demand for deposits in period 3 [t’t3 + (1 - t’)t3 = t3], all the remaining
agents receive x33*. A nontype 1 agent p articipates in the bank run in period 1,
if his expected utility is greater than waiting to withdraw in later periods:
If this condition is satisfied and all nontype 1 agents believe that all other
agents are going to run in period 1, they also run. The proportions of agents of
each type that are able to withdraw is straightforwardly derived from the
above sequence. n
know their identity. If type 3 agents knew their type in period 1 they would
not run, because they are assured that they can withdraw more in period 3.
But then there is no excess demand for period 2 withdrawals and type 2 agents
are better off withdrawing in period 2 than running in period 1. It is because
all agents discover their type in period 1 in the three-period model that there is
no bank-run equilibrium with the suspension of convertibility. The assumption
that agents’ preferences are revealed over time is in the spirit of banking
analysis based on agents having unknown liquidity demands.
Also, a bank-run equilibrium does not exist if type 1 agents prefer to
consume in period 3 over period 2, 04 > O:S,/L,. With such preferences, there
is no excess demand for period 2 withdrawals, because if there were, there
would be an excess supply of period 3 payments (at rate x: * ) and type 1 and
3 agents could do better by withdrawing in period 3. Hence, nontype 1 agents
wait until period 2 to discover their specific type and no bank run occurs.
Nontype 1 agents face a greater temptation to participate in a bank run if
withdrawals can be reinvested in period 1 in a newly created bank. This bank
is assumed to be able to buy a two-period productive asset in period 1 that has
a gross rate of return S’ > 1 in period 3. The original bank is only viable if
nontype 1 agents are no worse off keeping their money in the old bank when
there is no run in period 1:
tsP44*)+;r;-fit3 ( p)*u(x;*)
t2
t2+
t2
’- ,,,,,PG) + gp~P~‘4~:),
t2+
t2
GP43) + t2
*3 ( p )‘2.4($) >z.
This section considers a policy which allows the bank to liquidate assets and
alter payments in a bank run after having observed too many withdrawals
(f > t’ withdrawals) in period 1. To simplify the analysis, the long-run asset is
assumed to be perfectly liquid so that the bank invests all its deposits in the
long-run asset in period 0. Also, 63’ and 0: are assumed to be arbitrarily small
so that type 1 and 2 agents always prefer to consume in period 2 over period 3.
After t’ withdrawals of xi* in period 1, the bank can either suspend
convertibility or liquidate more assets to serve additional agents in period 1.
Suppose the bank liquidates assets in a bank run to serve additional agents in
period 1. Since type is not observable, it is optimal to pay the additional
withdrawers in period 1 the same payments xi. The bank should offer a low
payment xi to separate and cheaply serve the remaining type 1 agents in
period 1. A necessary condition for type 1 agents to accept such a payment is
xi 2 8:x,. Therefore, the bank sets xi = @x,. As 0: < l/S,, the strategy of
separating type 1 agents leaves more assets per capita for nontype 1 agents
withdrawing in later periods. Therefore, this policy dominates the policy of
suspending convertibility in period 1.
Under the separation policy the program to maximize the expected utility of
the remaining nontype 1 agents in period 1 is
(1 - tyx, + (1 - t’)t’x,
I - tlx;* - (1 - tl)tle:x2 =
s, L, ’
A nontype 1 agent is made better off by running when all others run if
(t2 + pt3)
pu(x:*) ’ $-+(Pu(P,) + Pf3d~3)),
1 - t1
With perfectly liquid assets and a flexible payment policy other examples
where bank runs cannot be prevented share similar features. The differences
between the optimal payments is small. Thus, xi* is relatively large and a
temptation to period 1 runners. The large period 1 payments reduce the assets
available for later periods. The other feature is that 0: is large.6 This means
the bank cannot cheaply separate and serve the remaining type 1 agents in
period 1. If restrictions are put on policy or assets are illiquid, the condition
for the bank-run equilibrium becomes less restrictive. For example the condi-
tion in Proposition 1 is the best policy for preventing a run when assets are
illiquid and payments are inflexible.
Finally, note that if the bank can anticipate a bank run and alter payments
to all agents including the first t’ agents, a run may be averted. For instance,
in Bental, Eckstein, and Peled (1989) and Freeman (1988) a bank run is
explicitly modelled as a ‘sunspot equilibrium’. Runs in these papers can be
prevented because the bank can observe and condition payments on the
sunspot. However, such a policy does not achieve optimal risk sharing,
because type 1 agents receive too little in period 1.
7. Other institutions
6There is a tradeoff between 0: and x i* to satisfy the condition for a bank-run equilibrium.
This tradeoff can be reduced by increasing the concavity of U(X). For example, if u(x) =
-1/(2x2), a smaller first-period payment x1I* -- 1 290 is consistent with a smaller substitutton
coefficient 0: = 0.12.
‘Taxes can be pard wtth deposits. Diamond and Dybvig constder a scheme where the tax does
not always cover the entire amount of the excess withdrawals and some assets are liquidated
prematurely. The altemattve mechanism considered here works even if assets are completely
illiquid.
M. Engrneer, Bank runs and the suspensron of deposit convertibility 453
“Without the isolation of agents a credit market may exist. Jacklin (1987) shows that a credit
market is inconsistent with bank deposits that provides liquidity.
91n the three-period model, r2 = 1 - ti. Thus, if t1 can be determined, x:* can be calculated.
Diamond and Dybvig use deposit insurance to face agents with payoffs such that they have a
dominant strategy to withdraw only in the period of their consumption shock. Thus, t1 is inferred.
454 M. Engineer, Bank runs and the suspemon of deposit convertibrht~
References
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international borrowing, Working paper (Technion-Israel, Institute of Technology).
Bryant, John, 1980, A model of bank reserves, bank runs and deposit insurance, Journal of
Banking and Finance 4,335-344.
Chari, V.V and Ravi Jagannathan, 1988, Banking panics, information, and rational expectations
equilibrium, Journal of Finance 63, 749-763.
Diamond, D. and P. Dybvig. 1983, Bank runs, deposit insurance, and liquidity, Journal of
Political Economy 91, 401-419.
Freeman, Scott, 1988. Bankmg as the provision of liquidity, Journal of Business 61, 45-64.
Gorton, Gary, 1985, Bank suspension of convertibility, Journal of Monetary Economics 15,
177-193.
Jacklin, Charles, 1987, Demand deposits, trading restrictions, and risk sharing, in: E. Prescott and
N. Wallace, eds., Contractual arrangements for intertemporal trade (University of Minnesota
Press, Minneapolis, MN) 26-47.
Jacklin, Charles and Sudipto Bhattacharya, 1988, Distinguishing panics and information-based
bank runs: Welfare and policy implications, Journal of Political Economy 96, 568-593.
Peare, Paula, 1988, The creation of liquidity by financial institutions: A framework for welfare
and policy analysis, Working paper (Queen’s University, Kingston, Ont.).
Postlewaite, Andrew and Xavier Vives, 1987, Bank runs as an equilibrium phenomena, Journal of
Political Economy 95.485-491.
Wallace, Neil, 1988, Another attempt to explain an illiquid banking system: The Diamond and
Dybvig model with sequential service taken seriously, Federal Reserve Bank of Minneapolis
Quarterly Review, Fall, 3-16.
“Jacklin pomts out that with more general ‘smooth’ preferences (such that each agent receives
optimal payments in more than one period) that the exchange of ex-dividend shares generally
cannot achieve the optimal allocation whereas complex demand deposit contracts can.