Money and Modern Banking without Bank Runs

Bank runs in the literature take the form of withdrawals of demand deposits payable in real goods, which deplete a …xed reserve of goods in the banking system. That framework describes traditional bank runs based on currency withdrawals as occurred historically in the U.S. and more recently in developing countries. However, in a modern banking system, large withdrawals typically take the form of electronic payments within a clearinghouse system of banks. These transfers shift balances among banks, with no analog of a depletion of a scarce reserve from the banking system. A new framework of nominal demand deposits repayable in money within a clearinghouse can examine bank run threats in a modern developed economy. This approach shows that interbank lending and monetary prices may be able to prevent pure liquidity-driven bank runs, demonstrating the resiliency of modern banking systems to excessive withdrawals. This …nding suggests that the rationalization for deposit insurance based on the Diamond-Dybvig model of real demand deposits holds for developing countries but not necessarily for developed countries. JEL Classi…cation: G21, G28, E42 Keywords: Bank runs, nominal contracts, demand deposits, interbank market, clearinghouse, payments, deposit insurance Email: [email protected]. This paper is a revised portion of a previously circulated paper, “Money and Modern Bank Runs,”which is the …rst chapter of my dissertation thesis at Princeton. I am grateful to my advisors Franklin Allen, Ben Bernanke and Patrick Bolton, and to Ken Ayotte, Markus Brunnermeier, Ed Green, Yair Listokin, Guido Lorenzoni, Antoine Martin, Jamie McAndrews, Cyril Monnet, Wei Xiong, seminar participants at Federal Reserve Bank of Chicago, Federal Reserve Bank of New York, Federal Reserve Bank of Richmond, Federal Reserve Board of Governors, FDIC, NYU Stern, Princeton, UNC Chapel Hill Kenan-Flager, Wharton, Sveriges Riksbank Workshop on “Banking, Financial Stability and the Business Cycle,” 2004 SED Annual Meeting (Florence), 2005 FMA Annual Meeting (Chicago), JBF 30th Anniversary Conference (Beijing) and 2006 FIRS Conference (Shanghai) for helpful comments and conversations. The views expressed in this paper are those of the author and do not necessarily re‡ect the views of the Federal Reserve Bank of New York or the Federal Reserve System. All errors are mine.