Should bank runs be prevented?

Abstract

This paper extends Diamond and Dybvig’s model [J. Political Economy 91 (1983) 401] to a framework in which bank assets are risky, there is aggregate uncertainty about the demand for liquidity in the population and some individuals receive a signal about bank asset quality. Others must then try to deduce from observed withdrawals whether an unfavorable signal was received by this group or whether liquidity needs happen to be high. In this environment, both information-induced and pure panic runs will occur. However, banks can prevent them by designing the deposit contract appropriately. It is shown that in some cases it is optimal for the bank to prevent runs but there are situations where the bank run allocation may be welfare superior.