Bank panics and scale economies ∗

A bank panic is an expectation-driven redemption event that results in a self-fulfilling prophecy of losses on demand deposits. From the standpoint of theory in the tradition of Diamond and Dybvig (1983) and Green and Lin (2003), it is surprisingly diffi cult to generate bank panic equilibria if one allows for a plausible degree of contractual flexibility. A common assumption employed in the standard banking model is that returns are linear in the scale of investment. Instead, we assume the existence of a fixed investment cost, so that a higher riskadjusted rate of return is available only if investment exceeds a minimum scale requirement. With this simple and empirically-plausible modification to the standard model, we find that bank panic equilibria emerge easily and naturally, even under highly flexible contractual arrangements. While bank panics can be eliminated through an appropriate policy, it is not always desirable to do so. We use our model ∗We thank Todd Keister for his many insightful comments. We would also like to thank seminar participants at the 2nd Annual Missouri Macro Workshop, the Federal Reserve Banks of Chicago and St. Louis, the National University of Singapore and Simon Fraser University. The views expressed here are our own and should not be attributed to the Federal Reserve Banks of Chicago and St. Louis, or the Federal Reserve System. JEL Codes: G01, G21, G28