Bank Runs and Institutions: The Perils of Intervention

Governments typically respond to a run on the banking system by temporarily freezing deposits and by rescheduling payments to depositors. Depositors may even be required to demonstrate an urgent need for funds before being allowed to withdraw. We study ex post efficient policy responses to a bank run and the ex ante incentives these responses create. Given that a run is underway, the efficient response is typically not to freeze all remaining deposits, since this would impose heavy costs on individuals with urgent withdrawal needs. Instead, (benevolent) government institutions would allow additional withdrawals, creating further strain on the banking system. We show that when depositors anticipate these extra withdrawals, their incentive to participate in the run actually increases. In fact, ex post efficient interventions can generate the conditions necessary for a self-fulfilling run to occur. Forthcoming in the American Economic Review. We thank Roberto Chang, Doug Diamond and seminar participants at Rutgers University, the Federal Reserve Bank of Richmond, Universidad de Alicante, Universidad de San Andrés, the Society for Economic Dynamics meetings, the Midwest Macro meetings, the North American Meeting of the Econometric Society, the Cornell-Penn State macroeconomics workshop, and the SAET conference in Vigo, Spain, for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve Bank of Richmond, or the Federal Reserve System.