Demand Deposit Contracts and the Probability of Bank Runs! Itay Goldstein* and Ady Pauzner** First version: August, 1999 This version: April, 2000 ABSTRACT We extend the Diamond and Dybvig model of bank runs by assuming that agents do not have common knowledge regarding the fundamentals of the economy, but rather receive slightly noisy signals. The new model has a unique equilibrium in which the fundamen- tals determine whether a bank run would occur. This lets us compute the probability of a bank run and relate it to the parameters of the demand deposit contract. We find that offering a higher return to agents demanding early withdrawal makes the bank more vulnerable to runs. Nonetheless, we show that even when this drawback is taken into account, demand deposit contracts still improve the welfare of agents. ! This paper is part of Itay Goldstein's Ph.D. dissertation, under the supervision of Elhanan Helpman. We thank Joshua Aizenman, Joseph Djivre, Elhanan Helpman, Zvi Hercowitz, Leonardo Leiderman, Nissan Liviatan, Stephen Morris, Assaf Razin, Dani Tsiddon, and Oved Yosha for helpful comments. * Research Department, Bank of Israel and the Eitan Berglas School of Economics, Tel Aviv University. E-mail:
[email protected] ** The Eitan Berglas School of Economics, Tel Aviv University. E-mail:
[email protected]. 1. Introduction: Banks often finance long-term investments with short-term liabilities. While this can have obvious welfare benefits, it makes banks vulnerable to ‘runs’. A run occurs when investors rush to withdraw their deposits, believing that the bank is bound to fail. As a result, the bank is forced to liquidate investments at a loss and indeed fails.