Academic journal article Economic Commentary (Cleveland)

Optimal Deposit Contracts: Do-It-Yourself Bank-Run Prevention for Banks

Academic journal article Economic Commentary (Cleveland)

Optimal Deposit Contracts: Do-It-Yourself Bank-Run Prevention for Banks

Article excerpt

The need for federal deposit insurance is often based on the claim that it prevents bank runs and makes the banking system more stable. But research shows that banks could prevent bank runs by constructing their deposit contracts appropriately, and, in the absence of deposit insurance, they would do so in their own self interest. Federal deposit insurance may be useful as insurance per se-protecting depositors against unforeseen accidents-but it should not be considered necessary for banking system stability.

Government provision of deposit insurance is often rationalized on the grounds that it stabilizes the banking system by removing the incentives for depositors to engage in bank runs. Even free market luminaries such as Milton Friedman have credited federal deposit insurance for the relative stability of the United States' banking system after World War II. The perception that deposit insurance improves the stability of the banking industry has been reinforced by a number of theoretical papers on bank runs, including the seminal work in this area by Douglas Diamond and Philip Dybvig.

However, as illustrated by the 1980s savings and loan debacle and more recent regional banking problems in the United States, deposit insurance is not a panacea. By effectively eliminating bank runs, deposit insurance has the unintended effect of reducing market discipline and increasing incentives for banks to take on risk. While deposit insurance may be effective in eliminating potentially destabilizing bank runs, it is far from clear that deposit insurance is the best way to promote the stability of banks and the banking system.

Despite the received wisdom that banks are prone to instability, a careful review of the economic literature on the topic suggests otherwise. Recent theoretical research, in particular, shows that banks themselves can prevent bank runs by modifying their demand deposit contracts. It turns out that in the absence of deposit insurance, banks will try to protect themselves from being the victim of bank runs by choosing an appropriate financial structure. In the end, it is difficult to tell a coherent story in which banks are inherently unstable.

* Bank Runs

A bank run occurs when depositors believe that their bank will be unable to honor all of its deposit liabilities; depositors rush to the bank and attempt to withdraw as much of their money as they can, in order to avoid losing all or most of it. Given that a bank holds only a small fraction of its assets in the form of cash, a bank run can be disruptive because the bank will have to liquidate its noncash assets in order to meet the demands of its depositors.

In spite of these disruption costs, in some circumstances a bank run may not be such a bad thing. If a bank is insolvent, then, from society's point of view, it is optimal that the bank be dissolved, and the sooner the better. A bank run can send a very visible signal that something may be wrong; if the bank is indeed insolvent, a run may be an expedient way to bring about the optimal dissolution. But if the depositors' beliefs are incorrect and the bank is actually solvent prior to the bank run, then a bank run would be a very bad thing if it resulted in a solvent bank becoming insolvent.

How susceptible are banks in general to runs of the sort that turn solvent banks into insolvent ones? This is actually a hard question to answer. Although we have seen very few bank runs since the Great Depression-which might lead one to conclude that the banking sector is stable-federal deposit insurance, which came into existence during the Great Depression, may explain this. If depositors understand that their deposits are guaranteed to pay off up to some maximum amount (which today is $100,000), they will have little or no incentive to ever run on a bank.

Prior to federal deposit insurance, bank runs were a bit more commonplace. But it is difficult to determine the extent to which solvent banks became insolvent following a run. …

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