Optimal Banking Contracts and Financial Fragility

We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the (constrained) efficient allocation of resources in closed-form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies. JEL Classification Numbers: G21,G01, D82 We thank seminar participants at the European Central Bank, the IESE Business School, the University of Iowa, the Federal Reserve Bank of Richmond, 2010 Winter Meetings of the Econometric Society and the 2012 Meetings of the Society for Economic Dynamics for useful comments. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of Richmond or the Federal Reserve System.