Bank Runs, Deposit Insurance, and Liquidity

This paper 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 pri-vately observed risks which lead to a demand for liquidity. Tradi-tional
demand deposit contracts which provide liquidity have multi-ple 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 provi-sion of deposit insurance can produce
superior contracts.

I. Introduction

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.
In a panic with 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
loans make bank runs and institutions to prevent them a current policy issue, as
shown by recent aborted runs.' (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 we must ensure that banks will not be left
vulnerable to runs. Through careful description and analysis, Friedman and
Schwartz (1963) have provided substantial insight into the properties of past bank
runs in the United States. Existing theoretical analysis has ne-glected to explain
why bank contracts are less stable than other types of financial contracts or to
investigate the strategic decisions that de-positors face. The model we present has
an explicit economic role for banks to perform: the transformation of illiquid
assets into liquid liabilities. The analyses of Patinkin (1965, chap. 5), Tobin
(1965), and Niehans (1978) provide insights into characterizing the liquidity of
assets. This paper gives the first explicit analysis of the demand for liquidity and
the "transformation" service provided by banks. Unin-sured demand deposit
contracts are able to provide liquidity but leave banks vulnerable to runs. This
vulnerability occurs because there are multiple equilibria with differing levels of
confidence. Our model demonstrates three important points. First, banks issu-ing
demand deposits can improve on a competitive market by provid-ing better risk
sharing among people who need to consume at differ-ent random times. Second,
the demand deposit contract providing this improvement has an undesirable
equilibrium (a bank run) in which all depositors panic and withdraw immediately,
including even those who would prefer to leave their deposits in if they were not
concerned about the bank failing. Third, bank runs cause real eco-nomic problems
because even "healthy" banks can fail, causing the recall of loans and the
termination of productive investment. In addi-tion, our model provides a suitable
framework for analysis of the devices traditionally used to stop or prevent bank
runs, namely, sus-pension of convertibility and demand deposit insurance (which
works similarly to a central bank serving as "lender of last resort"). The illiquidity
of assets enters our model through the economy's riskless production activity. The
technology provides low levels of output per unit of input if operated for a single
period but high levels of output if operated for two periods. The analysis would be
the same if the asset were illiquid because of selling costs: one receives a low
return if unexpectedly forced to "liquidate" early. In fact, this illiquid-ity is a
property of the financial assets in the economy in our model, even though they are
traded in competitive markets with no transac-tion costs. Agents will be concerned
about the cost of being forced into early liquidation of these assets and will write
contracts which reflect this cost. Investors face private risks which are not directly
insurable because they are not publicly verifiable. Under optimal risk sharing, this
private risk implies that agents have different time pat-terns of return in different
private information states and that agents want to allocate wealth unequally across
private information states. Because only the agent ever observes the private
information state, it is impossible to write insurance contracts in which the payoff
depends directly on private information, without an explicit mechanism for
information flow. Therefore, simple competitive markets cannot pro-vide this
liquidity insurance. Banks are able to transform illiquid assets by offering
liabilities with a different, smoother pattern of returns over time than the illiquid
assets offer. These contracts have multiple equilibria. If confidence is maintained,
there can be efficient risk sharing, because in that equilib-rium a withdrawal will
indicate that a depositor should withdraw under optimal risk sharing. If agents
panic, there is a bank run and incentives are distorted. In that equilibrium,
everyone rushes in to withdraw their deposits before the bank gives out all of its
assets. The bank must liquidate all its assets, even if not all depositors withdraw,
because liquidated assets are sold at a loss. Illiquidity of assets provides the
rationale both for the existence of banks and for their vulnerability to runs. An
important property of our model of banks and bank runs is that runs are costly and
reduce social welfare by interrupting production (when loans are called) and by
destroying optimal risk sharing among depositors. Runs in many banks would
cause economy-wide economic problems. This is consis-tent with the Friedman
and Schwartz (1963) observation of large costs imposed on the U.S. economy by
the bank runs in the 1930s, although they attribute the real damage from bank runs
as occurring through the money supply. Another contrast with our view of how
bank runs do economic damage is discussed by Fisher (1911, p. 64).2 In this view,
a run occurs because the bank's assets, which are liquid but risky, no longer cover
the nominally fixed liability (demand deposits), so depositors with-draw quickly to
cut their losses. The real losses are indirect, through the loss of collateral caused
by falling prices. In contrast, a bank run in our model is caused by a shift in
expectations, which could depend on almost anything, consistent with the
apparently irrational observed behavior of people running on banks. We analyze
bank contracts that can prevent runs and examine their optimality. We show that
there is a feasible contract that allows banks both to prevent runs and to provide
optimal risk sharing by convert-ing illiquid assets. The contract corresponds to
suspension of convert-ibility of deposits (to currency), a weapon banks have
historically used against runs. Under other conditions, the best contract that banks
can offer (roughly, the suspension-of-convertibility contract) does not achieve
optimal risk sharing. However, in this more general case there is a contract which
achieves the unconstrained optimum when government deposit insurance is
available. Deposit insurance is shown to be able to rule out runs without reducing
 the ability of banks to transform assets. What is crucial is that deposit insurance
frees the asset liquidation policy from strict dependence on the volume of with-
drawals. Other institutions such as the discount window ("lender of last resort")
may serve a similar function; however, we do not model this here. The taxation
authority of the government makes it a natu-ral provider of the insurance, although
there may be a competitive fringe of private insurance. Government deposit
insurance can improve on the best allocations that private markets provide. Most
of the existing literature on de-posit insurance assumes away any real service from
deposit insurance, concentrating instead on the question of pricing the insurance,
taking as given the likelihood of failure (see, e.g., Merton 1977, 1978; Kare-ken
and Wallace 1978; Dothan and Williams 1980). Our results have far-reaching
policy implications, because they im-ply that the real damage from bank runs is
primarily from the direct damage occurring when recalling loans interrupts
production. This implies that much of the economic damage in the Great
Depression was caused directly by bank runs. A study by Berrianke (in press)
supports our thesis, as it shows that bank runs give a better predictor of economic
distress than money supply. The paper proceeds as follows. In the next section, we
analyze a simple economy which shows that banks can improve the risk sharing of
simple competitive markets by transforming illiquid assets. We show that such
banks are always vulnerable to runs. In Section III, we analyze the optimal bank
contracts that prevent runs. In Section IV, we analyze bank contracts, dropping the
previous assumption that the volume of withdrawals is deterministic. Deposit
insurance is analyzed in Section V. Section VI concludes the paper.

II. The Bank's Role in Providing Liquidity

Banks have issued demand deposits throughout their history, and economists have
long had the intuition that demand deposits are a vehicle through which banks
fulfill their role of turning illiquid assets into liquid assets. In this role, banks can
be viewed as providing insur-ance that allows agents to consume when they need
to most. Our simple model shows that asymmetric information lies at the root of
liquidity demand, a point not explicitly noted in the previous literature. The model
has three periods (T = 0, 1, 2) and a single homoge-neous good. The productive
technology yields R > 1 units of output in period 2 for each unit of input in period
0. If production is inter-rupted in period 1, the salvage value is just the initial
investment. Therefore, the productive technology is represented by T= 0 T= 1 T=
2 -1 R 0, where the choice between (0, R) and (1, 0) is made in period 1. (Of
course, constant returns to scale implies that a fraction can be done in each option.)
One interpretation of the technology is that long-term capital in-vestments are
somewhat irreversible, which appears to be a rea-sonable characterization. The
results would be reinforced (or can be alternatively motivated) by any type of
transaction cost associated with selling a bank's assets before maturity. See
Diamond (1980) for a model of the costly monitoring of loan contracts by banks,
which implies such a cost. All consumers are identical as of period 0. Each faces a
privately observed, uninsurable risk of being of type 1 or of type 2. In period 1,
each agent (consumer) learns his type. Type 1 agents care only about consumption
in period 1 and type 2 agents care only about consump-tion in period 2. In
addition, all agents can privately store (or "hoard") consumption goods at no cost.
This storage is not publicly observable. No one would store between T = 0 and T =
1, because the productive technology does at least as well (and better if held until
T = 2). If an agent of type 2 obtains consumption goods at T = 1, he will store
them until T = 2 to consume them. Let CT represent goods "received" (to store or
consume) by an agent at period T. The pri-vately observed consumption at T = 2
of a type 2 agent is then what he stores from T = 1 plus what he obtains at T = 2,
or cl + c2. In terms of this publicly observed variable CT the discussion above
implies that each agent has a state-dependent utility function (with the state private
information), which we assume has the form U(c1, c2; 0) =8u(ci) if j is of type 1 in
state 0 pU(Cl + C2) ifj is of type 2 in state 0, where 1 ? p > R - and u: R + + -* R is
twice continuously differ-entiable, increasing, strictly concave, and satisfies Inada
conditions u0(0) = o and u'(oo) = 0. Also, we assume that the relative risk-aversion
coefficient -cu"(c)/u'(c) > 1 everywhere. Agents maximize expected utility, E[u(cl,
C2; 0)], conditional on their information (if any). A fraction t C (0, 1) of the
continuum of agents are of type 1 and, conditional on t, each agent has an equal
and independent chance of being of type 1. Later sections will allow t to be
random (in which case, at period 1, consumers know their own type but not t), but
for now we take t to be constant. To complete the model, we give each consumer
an endowment of 1 unit in period 0 (and none at other times). We consider first the
competitive solution where agents hold the assets directly, and in each period there
is a competitive market in claims on future goods. It is easy to show that because
of the constant returns technology, prices are determined: the period 0 price of
period 1 consumption is 1, and the period 0 and 1 prices of period 2 consumption
are R- 1. This is because agents can write only uncontingent contracts as there is
no public information on which to condition. Contracting in period T = 0, all
agents (who are then identical) will establish the same trades and each will invest
his endowment in the production technology. Given this identical position of each
agent at T = 0, there will be trade in claims on goods for consumption at T = 1 and
at T = 2. Each has access to the same technology and each can choose any positive
linear combination of cl = 1 and C2 = R. Each individual's production set is
proportional to the aggregate set, and for there to be positive produc-tion of both cl
and c2, the period T =1 price of c2 must be R - 1. Given these prices, there is never
any trade, and agents can do no better or worse than if they produced only for their
own consumption. Letting C' be consumption in period k of an agent who is of
type i, the agents choose cl = 1, c1 = C2 = 0, and c2 = R, since type l's always
interrupt production but type 2's never do. By comparison, if types were publicly
observable as of period 1, it would be possible to write optimal insurance contracts
that give the ex ante (as of period 0) optimal sharing of output between type 1 and
type 2 agents. The optimal consumption {c}k satisfies c2* = C 0 = c

(those who can, delay consumption), U'(C ) = pRu'(c 2) (lb) (marginal utility in
line with marginal productivity), and tc1J + [(1 - t)c2* IR] = 1 (Ic) (the resource
constraint). By assumption, pR > 1, and since relative risk aversion always
exceeds unity, equation (1) implies that the optimal consumption levels satisfy cl >
1 and c2 < R.3 Therefore, there is room for improvement on the competitive
outcome (cl = 1 and c2 = R). Also, note that c2 > c by equation (Ib), since pR > 1.
The optimal insurance contract just described would allow agents to insure against
the unlucky outcome of being a type 1 agent. This contract is not available in the
simple contingent-claims market. Also, the lack of observability of agents' types
rules out a complete market of Arrow-Debreu state-contingent claims, because this
market would require claims that depend on the nonverifiable private information.
Fortunately it is potentially possible to achieve the optimal insurance contract,
since the optimal contract satisfies the self-selection con-straints.4 We argue that
banks can provide this insurance: by provid- 3The proof of this is as follows:
pRu'(R) < Ru'(R) = 1 u'(1) + j a [yu'(y)]dy rR u'(l) + [u'(y) + u"(y)]dy < u'l) as u' >
0 and (V My) -u"(-y)-y/u'(-y) > 1. Because u'(Q) is decreasing and the resource
constraint (ic) trades off cU* against cX, the solution to (1) must have cU > 1 and
c2* < R. 4 The self-selection constraints state that no agent envies the treatment by
the market of other indistinguishable agents. In our model, agents' utilities depend
on only their consumption vectors across time and all have identical endowments.
Therefore, the self-selection constraints are satisfied if no agent envies the
consumption bundle of any other agent. This can be shown for optimal risk sharing
using the properties described after (1). Because cl* > 1 and crI = 0, type 1 agents
do not envy type 2 agents. Furthermore, because c2 + C2 C2* > C = c + c'*, type 2
agents do not envy type 1 agents. Because the optimal contract satisfies the self-
selection constraints, there is necessarily a contract structure which implements it
as a Nash equilibrium-the ordi-nary demand deposit is a contract which will work.
However, the optimal allocation is not the unique Nash equilibrium under the
ordinary demand deposit contract. An-other inferior equilibrium is what we
identify as a bank run. Our model gives a real-world example of a situation in
which the distinction between implementation as a Nash equilibrium and
implementation as a unique Nash equilibrium is crucial (see also Dybvig and
Spatt, in press, and Dybvig and Jaynes 1980).

ing liquidity, banks guarantee a reasonable return when the investor cashes in
before maturity, as is required for optimal risk sharing. To illustrate how banks
provide this insurance, we first examine the tra-ditional demand deposit contract,
which is of particular interest be-cause of its ubiquitous use by banks. Studying the
demand deposit contract in our framework also indicates why banks are
susceptible to runs. In our model, the demand deposit contract gives each agent
with-drawing in period 1 a fixed claim of r1 per unit deposited at time 0.
Withdrawal tenders are served sequentially in random order until the bank runs out
of assets. This approach allows us to capture the flavor of continuous time (in
which depositors deposit and withdraw at dif-ferent random times) in a discrete
model. Note that the demand deposit contract satisfies a sequential service
constraint, which specifies that a bank's payoff to any agent can depend only on
the agent's place in line and not on future information about agents behind him in
line. We are assuming throughout this paper that the bank is mutually owned (a
"mutual") and liquidated in period 2, so that agents not withdrawing in period 1 get
a pro rata share of the bank's assets in period 2. Let V1 be the period 1 payoff per
unit deposit withdrawn which depends on one's place in line at T = 1, and let V2
be the period 2 payoff per unit deposit not withdrawn at T = 2, which depends on
total withdrawals at T = 1. These are given by VI(fj, ri) = 1 (2) and V2(f, rl) = max
{R(1 - r f)/(1 - f), 0}, (3) wherefj is the number of withdrawers' deposits serviced
before agent j as a fraction of total demand deposits; f is the total number of
demand deposits withdrawn. Let w1 be the fraction of agents' depos-its that he
attempts to withdraw at T = 1. The consumption from deposit proceeds, per unit of
deposit of a type 1 agent, is thus given by wjVi(fj, rl), while the total consumption,
from deposit proceeds, per unit of deposit of a type 2 agent is given by wjV1(fj, rl)
+ (1 - Wj)V2(f, rl).

Equilibrium Decisions

The demand deposit contract can achieve the full-information op-timal risk
sharing as an equilibrium. (By equilibrium, we will always refer to pure strategy
Nash equilibrium5 -and for now we will as-sume all agents are required to deposit
initially.) This occurs when ri = Cl', that is, when the fixed payment per dollar of
deposits with-drawn at T = 1 is equal to the optimal consumption of a type 1 agent
given full information. If this contract is in place, it is an equilibrium for type 1
agents to withdraw at T = 1 and for type 2 agents to wait, provided this is what is
anticipated. This "good" equilibrium achieves optimal risk sharing.6 Another
equilibrium (a bank run) has all agents panicking and trying to withdraw their
deposits at T = 1: if this is anticipated, all agents will prefer to withdraw at T = 1.
This is because the face value of deposits is larger than the liquidation value of the
bank's assets. It is precisely the "transformation" of illiquid assets into liquid as-
sets that is responsible both for the liquidity service provided by banks and for
their susceptibility to runs. For all r, > 1, runs are an equilib-rium.7 If r1 = 1, a
bank would not be susceptible to runs because VI(fj, 1) < V2(f, 1) for all values of
0 - fj , f; but if r1 = 1, the bank simply mimics direct holding of the assets and is
therefore no im-provement on simple competitive claims markets. A demand
deposit contract which is not subject to runs provides no liquidity services. The
bank run equilibrium provides allocations that are worse for all agents than they
 would have obtained without the bank (trading in the competitive claims market).
In the bank run equilibrium, every-one receives a risky return that has a mean one.
Holding assets di-rectly provides a riskless return that is at least one (and equal to
R > 1 if an agent becomes a type 2). Bank runs ruin the risk sharing be-tween
agents and take a toll on the efficiency of production because all production is
interrupted at T = 1 when it is optimal for some to continue until T = 2. If we take
the position that outcomes must match anticipations, the inferiority of bank runs
seems to rule out observed runs, since no one would deposit anticipating a run.
However, agents will choose to de-posit at least some of their wealth in the bank
even if they anticipate a positive probability of a run, provided that the probability
is small enough, because the good equilibrium dominates holding assets directly.
This could happen if the selection between the bank run equi-librium and the good
equilibrium depended on some commonly ob-served random variable in the
economy. This could be a bad earnings report, a commonly observed run at some
other bank, a negative government forecast, or even sunspots.8 It need not be
anything fun-damental about the bank's condition. The problem is that once they
have deposited, anything that causes them to anticipate a run will lead to a run.
This implies that banks with pure demand deposit contracts will be very concerned
about maintaining confidence because they realize that the good equilibrium is
very fragile. The pure demand deposit contract is feasible, and we have seen that it
can attract deposits even if the perceived probability of a run is positive. This
explains why the contract has actually been used by banks in spite of the danger of
runs. Next, we examine a closely related contract that can help to eliminate the
problem of runs.

III. Improving on Demand Deposits: Suspension of Convertibility

The pure demand deposit contract has a good equilibrium that achieves the full-
information optimum when t is not stochastic. How-ever, in its bank run
equilibrium, it is worse than direct ownership of assets. It is illuminating to begin
the analysis of optimal bank contracts by demonstrating that there is a simple
variation on the demand deposit contract which gives banks a defense against runs:
suspension of allowing withdrawal of deposits, referred to as suspension of con-
vertibility (of deposits to cash). Our results are consistent with the claim by
 Friedman and Schwartz (1963) that the newly organized Federal Reserve Board
may have made runs in the 1930s worse by preventing banks from suspending
convertibility: the total week-long banking "holiday" that followed was more
severe than any of the previous suspensions. If banks can suspend convertibility
when withdrawals are too numerous at T = 1, anticipation of this policy prevents
runs by re-moving the incentive of type 2 agents to withdraw early. The follow-ing
contract is identical to the pure demand deposit contract de-scribed in (2) and (3),
except that it states that any agent will receive nothing at T = 1 if he attempts to
withdraw at T = 1 after a fraction 1 < rf' of all deposits have already been
withdrawn-note that we redefine VI(-) and V20), VI(fj, ri) = {; ify 4 V2(f, ri) =
max (1 -Gfrl)R ( I rI)R where the expression for V2 assumes that 1 - rl > 0.
Convertibility is suspended when fj = f, and then no one else "in line" is allowed to
withdraw at T = 1. To demonstrate that this con-tract can achieve the optimal
allocation, let r1 = c'l and choose any fE {t, [(R - rl)/rl(R - 1)]}. Given this
contract, no type 2 agent will withdraw at T = 1 because no matter what he
anticipates about others' withdrawals, he receives higher proceeds by waiting until
T = 2 to withdraw; that is, for allfandfj - If, V2() > VI (). All of the type l's will
withdraw everything at period 1 because period 2 consump-tion is worthless to
them. Therefore, there is a unique Nash equilib-rium which hasf = t. In fact, this is
a dominant strategy equilibrium, because each agent will choose his equilibrium
action even if he antici-pates that other agents will choose nonequilibrium or even
irrational actions. This makes this contract very "stable." This equilibrium is
essentially the good demand deposit equilibrium that achieves op-timal risk
sharing. A policy of suspension of convertibility at f guarantees that it will never
be profitable to participate in a bank run because the liq-uidation of the bank's
assets is terminated while type 2's still have an incentive not to withdraw. This
contract works perfectly only in the case where the normal volume of withdrawals,
t, is known and not stochastic. The more general case, where t can vary, is
analyzed next.

IV. Optimal Contracts with Stochastic Withdrawals

The suspension of convertibility contract achieves optimal risk shar-ing when t is

known ex ante because suspension never occurs in equi-librium and the bank can
follow the optimal asset liquidation policy. This is possible because the bank
knows exactly how many withdraw-als will occur when confidence is maintained.
We now allow the frac-tion of type 1's to be an unobserved random variable, t. We
consider a general class of bank contracts where payments to those who with-draw
at T = 1 are any function of fj and payments to those who withdraw at T = 2 are
any function of f. Analyzing this general class will show the shortcomings of
suspension of convertibility. The full-information optimal risk sharing is the same
as before, except that in equation (1) the actual realization of t = t is used in place
of the fixed t. As no single agent has information crucial to learning the value of t,
the arguments of footnote 3 still show that optimal risk sharing is consistent with
self-selection, so there must be some mechanism which has optimal risk sharing as
a Nash equilib-rium. We now explore whether banks (which are subject to the con-
straint of sequential service) can do this too. From equation (1) we obtain full-
information optimal consumption levels, given the realization of i = t, of ci*(t) and
c 2*(t). Recall that c2(t) = c2 (t) = 0. At the optimum, consumption is equal for all
agents of a given type and depends on the realization of t. This im-plies a unique
optimal asset liquidation policy given t = t. This turns out to imply that uninsured
bank deposit contracts cannot achieve optimal risk sharing. PROPOSITION 1:
Bank contracts (which must obey the sequential service constraint) cannot achieve
optimal risk sharing when t is sto-chastic and has a nondegenerate distribution.
Proposition 1 holds for all equilibria of uninsured bank contracts of the general
form V1 (fj) and V2(f), where these can be any function. It obviously remains true
that uninsured pure demand deposit contracts are subject to runs. Any run
equilibrium does not achieve optimal risk sharing, because both types of agents
receive the same consumption. Consider the good equilibrium for any feasible
contract. We prove that no bank contract can attain the full-information optimal
risk sharing. The proof is straightforward, a two-part proof by contradic-tion.
Recall that the "place in line" /7is uniformly distributed over [0, t] if only type 1
agents withdraw at T = 1. First, suppose that the payments to those who withdraw
at T = 1 is a nonconstant function of fj over feasible values of t: for two possible
values of t, t1 and t2, the value of a period 1 withdrawal varies, that is, VI(tI) #&
VI(t2). This immediately implies that there is a positive probability of different
consumption levels by two type 1 agents who will withdraw at T = 1, and this
contradicts an unconstrained optimum. Second, assume the contrary: that for all
 possible realizations of t = t, VI (fj) is constant for allf E [0, t]. This implies that
cl(t) is a constant independent of the realization of t, while the budget constraint,
equation (ic), shows that 2(t c2(t) will vary with t (unless r, = 1, which is itself
inconsistent with optimal risk sharing). Constant cl(t) and varying ct2(t) contradict
op-timal risk sharing, equation (lb). Thus, optimal risk sharing is incon-sistent with
sequential service. Proposition 1 implies that no bank contract, including
suspension convertibility, can achieve the full-information optimum. Nonethe-less,
suspension can generally improve on the uninsured demand deposit contract by
preventing runs. The main problem occurs when convertibility is suspended in
equilibrium, that is, when the points where suspension occurs is less than the
largest possible realization of t. In that case, some type I agents cannot withdraw,
which is ineffi-cient ex post. This can be desirable ex ante, however, because the
threat of suspension prevents runs and allows a relatively high value of rl. This
result is consistent with contemporary views about suspen-sion in the United
States in the period before deposit insurance. Al-though suspensions served to
short-circuit runs, they were "regarded as anything but a satisfactory solution by
those who experienced them, which is why they produced so much strong pressure
for mone-tary and banking reform" (Friedman and Schwartz 1963, p. 329). The
most important reform that followed was federal deposit insurance. Its impact is
analyzed in Section V

V. Government Deposit Insurance

Deposit insurance provided by the government allows bank contracts that can
dominate the best that can be offered without insurance and never do worse. We
need to introduce deposit insurance into the analysis in a way that keeps the model
closed and assures that no aggregate resource constraints are violated. Deposit
insurance guar-antees that the promised return will be paid to all who withdraw. If
this is a guarantee of a real value, the amount that can be guaranteed is
constrained: the government must impose real taxes to honor a deposit guarantee.
If the deposit guarantee is nominal, the tax is the (inflation) tax on nominal assets
caused by money creation. (Such taxation occurs even if no inflation results; in
any case the price level is higher than it would have been otherwise, so some
nominally de-nominated wealth is appropriated.) Because a private insurance com-
pany is constrained by its reserves in the scale of unconditional guarantees which it
can offer, we argue that deposit insurance proba-bly ought to be governmental for
this reason. Of course, the deposit guarantee could be made by a private
organization with some author-ity to tax or create money to pay deposit insurance
claims, although we would usually think of such an organization as being a branch
of government. However, there can be a small competitive fringe of commercially
insured deposits, limited by the amount of private collateral. The government is
assumed to be able to levy any tax that charges every agent in the economy the
same amount. In particular, it can tax those agents who withdrew "early" in period
T = 1, namely, those with low values of fj. How much tax must be raised depends
on how many deposits are withdrawn at T = I and what amount r1 was promised to
them. For example, if every deposit of one dollar were withdrawn at T = 1
(implying f = 1) and r1 = 2 were promised, a tax of at least one per capita would
need to be raised because totally liquidating the bank's assets will raise at most one
per capita at T = 1. As the government can impose a tax on an agent after he or she
has withdrawn, the government can base its tax on f, the realized total value of T =
1 withdrawals. This is in marked contrast to a bank, which must provide sequential
service and cannot reduce the amount of a withdrawal after it has been made. This
asymmetry allows a potential benefit from government intervention. The realistic
sequen-tial-service constraint represents some services that a bank provides but
which we do not explicitly model. With deposit insurance we will see that
imposing this constraint does not reduce social welfare. Agents are concerned with
the after-tax value of the proceeds from their withdrawals because that is the
amount that they can consume. A very strong result (which may be too strong)
about the optimality of deposit insurance will illuminate the more general reasons
why it is desirable. We argue in the conclusion that deposit insurance and the
Federal Reserve discount window provide nearly identical services in the context
of our model but confine current discussion to deposit insurance. PROPOSITION
2: Demand deposit contracts with government deposit insurance achieve the
unconstrained optimum as a unique Nash equi-librium (in fact, a dominant
strategies equilibrium) if the government imposes an optimal tax to finance the
deposit insurance. Proposition 2 follows from the ability of tax-financed deposit
insur-ance to duplicate the optimal consumptions C (t) = cl*(t), c2(t) = c2*(t),
c(t)= I0, c2(t) = 0 from the optimal risk sharing characterized in equation (1). Let
the government impose a tax on all wealth held at the beginning of period T = 1,
which is payable either in goods or in deposits. Let deposits be accepted for taxes
at the pretax amount of goods which could be obtained if withdrawn at T = 1. The
amount of tax that must be raised at T = 1 depends on the number of withdraw-als
then and the asset liquidation policy. Consider the proportionate tax as a function
off, v: [0, 1] -> [0, 1] given by T I c Ir(f) iff i 1 - r_1 if f >, where I is the greatest
possible realization of t. The after-tax proceeds, per dollar of initial deposit, of a
withdrawal at T = 1 depend on f through the tax payment and are identical for all f
tf . Denote these after-tax proceeds by VI( f), given by A1(f) = J c*(f) if f - t l1 if f
>. The net payments to those who withdraw at T = 1 determine the asset
liquidation policy and the after-tax value a withdrawal at T = 2. Any tax collected
in excess of that needed to meet withdrawals at 7 = 1 is plowed back into the bank
(to minimize the fraction of assets liquidated). This implies that the after-tax
proceeds, per dollar of initial deposit, of a withdrawal at T = 2, denoted by V2(f),
are given by | R{1 -[c=*(f)f]} iff2 V2(f) { R(1(I -R iff t. 1 -of Notice that V1(f) <
V2(f) for allf E [0, 1], implying that no type 2 agents will withdraw at T = 1 no
matter what they expect others to do. For allf C [0, 1], VI(f) > 0, implying that all
type 1 agents will withdraw at T = 1. Therefore, the unique dominant strategy
equilib-rium is f = t, the realization of t. Evaluated at a realization t, VI(f = t) = C
I(t) and V2(f = t) = [1 - tci*(t)]R = 1-t and the optimum is achieved. Proposition 2
highlights the key social benefit of government de-posit insurance. It allows the
bank to follow a desirable asset liq-uidation policy, which can be separated from
the cash-flow constraint imposed directly by withdrawals. Furthermore, it prevents
runs be-cause, for all possible anticipated withdrawal policies of other agents, it
never pays to participate in a bank run. As a result, no strategic issues of
confidence arise. This is a general result of many deposit insurance schemes. The
proposition may be too strong, as it allows the government to follow an
unconstrained tax policy. If a nonoptimal tax must be imposed, then when t is
stochastic there will be some tax distortions and resource costs associated with
government deposit insurance. If a sufficiently perverse tax provided the revenues
for insurance, social welfare could be higher without the insurance.

Deposit insurance can be provided costlessly in the simpler case where t is

nonstochastic, for the same reason that there need not be a suspension of
 convertibility in equilibrium. The deposit insurance guarantees that type 2 agents
will never participate in a run; without runs, withdrawals are deterministic and this
feature is never used. In particular, so long as the government can impose some tax
to finance the insurance, no matter how distortionary, there will be no runs and the
distorting tax need never be imposed. This feature is shared by a model of
adoption externalities (see Dybvig and Spatt, in press) in which a Pareto-inferior
equilibrium can be averted by an insurance policy which is costless in equilibrium.
In both models, the credible promise to provide the insurance means that the
promise will not need to be fulfilled. This is in contrast to privately provided
deposit insurance. Because insurance companies do not have the power of
taxation, they must hold reserves to make their promise credible. This illustrates a
reason why the government may have a natural advan-tage in providing deposit
insurance. The role of government policy in our model focuses on providing an
institution to prevent a bad equi-librium rather than a policy to move an existing
equilibrium. Gener-ally, such a policy need not cause distortion.

VI. Conclusions and Implications

The model serves as a useful framework for analyzing the economics of banking
and associated policy issues. It is interesting that the prob-lems of runs and the
differing effects of suspension of convertibility and deposit insurance manifest
themselves in a model which does not introduce currency or risky technology. This
demonstrates that many of the important problems in banking are not necessarily
related to those factors, although a general model will require their introduc-tion.
We analyze an economy with a single bank. The interpretation is that it represents
the financial intermediary industry, and withdraw-als represent net withdrawals
from the system. If many banks were introduced into the model, then there would
be a role for liquidity risk sharing between banks, and phenomena such as the
Federal Funds market or the impact of "bank-specific risk" on deposit insur-ance
could be analyzed. The result that deposit insurance dominates contracts which the
bank alone can enforce shows that there is a potential benefit from government
intervention into banking markets. In contrast to com-mon tax and subsidy
schemes, the intervention we are recommending provides an institutional
framework under which banks can operate smoothly, much as enforcement of
contracts does more generally. The riskless technology used in the model isolates
the rationale for deposit insurance, but in addition it abstracts from the choice of
bank loan portfolio risk. If the risk of bank portfolios could be selected by a bank
manager, unobserved by outsiders (to some extent), then a moral hazard problem
would exist. In this case there is a trade-off between optimal risk sharing and
proper incentives for portfolio choice, and introducing deposit insurance can
influence the portfolio choice. The moral hazard problem has been analyzed in
complete market settings where deposit insurance is redundant and can pro-vide no
social improvement (see Kareken and Wallace 1978; Dothan and Williams 1980),
but of course in this case there is no trade-off. Introducing risky assets and moral
hazard would be an interesting extension of our model. It appears likely that some
form of govern-ment deposit insurance could again be desirable but that it would
be accompanied by some sort of bank regulation. Such bank regulation would
serve a function similar to restrictive covenants in bond inden-tures. Interesting but
hard to model are questions of regulator "dis-cretion" which then arise. The
Federal Reserve discount window can, as a lender of last re-sort, provide a service
similar to deposit insurance. It would buy bank assets with (money creation) tax
revenues at T = 1 for prices greater than their liquidating value. If the taxes and
transfers were set to be identical to that of the optimal deposit insurance, it would
have the same effect. The identity of deposit insurance and discount window
services occurs because the technology is riskless. If the technology is risky, the
lender of last resort can no longer be as credible as deposit insurance. If the lender
of last resort were always required to bail out banks with liquidity problems, there
would be perverse incentives for banks to take on risk, even if bailouts occurred
only when many banks fail together. For instance, if a bailout is antici-pated, all
banks have an incentive to take on interest rate risk by mismatching maturities of
assets and liabilities, because they will all be bailed out together. If the lender of
last resort is not required to bail out banks uncondi-tionally, a bank run can occur
in response to changes in depositor expectations about the bank's credit
worthiness. A run can even occur in response to expectations about the general
willingness of the lender of last resort to rescue failing banks, as illustrated by the
unfor-tunate experience of the 1930s when the Federal Reserve misused its
discretion and did not allow much discounting. In contrast, deposit insurance is a
binding commitment which can be structured to retain punishment of the bank's
owners, board of directors, and officers in the case of a failure. The potential for
multiple equilibria when a firm's liabilities are more liquid than its assets applies
more generally, not simply to banks. Consider a firm with illiquid technology
which issues very short-term bonds as a large part of its capital structure. Suppose
one lender expects all other lenders to refuse to roll over their loans to the firm.
Then, it may be his best response to refuse to roll over his loans even if the firm
would be solvent if all loans were rolled over. Such liquidity crises are similar to
bank runs. The protection from creditors provided by the bankruptcy laws serves a
function similar to the sus-pension of convertibility. The firm which is viable but
illiquid is guaranteed survival. This suggests that the "transformation" could be
carried out directly by firms rather than by financial intermediaries. Our focus on
intermediaries is supported by the fact that banks di-rectly hold a substantial
fraction of the short-term debt of corpora-tions. Also, there is frequently a
requirement (or custom) that a firm issuing short-term commercial paper obtain a
bank line of credit sufficient to pay off the issue if it cannot "roll it over." A bank
with deposit insurance can provide "liquidity insurance" to a firm, which can
prevent a liquidity crisis for a firm with short-term debt and limit the firm's need to
use bankruptcy to stop such crises. This suggests that most of the aggregate
liquidity risk in the U.S. economy is chan-neled through its insured financial
intermediaries, to the extent that lines of credit represent binding commitments.
We hope that this model will prove to be useful in understanding issues in banking
and corporate finance.