Optimal Financial Crises

Empirical evidence suggests that banking panics are related to the business cycle and are not simply the
result of "sunspots." Panics occur when depositors perceive that the returns on bank assets are going to
be unusually low. We develop a simple model of this. In this setting, bank runs can be first-best efficient:
they allow efficient risk sharing between early and late withdrawing depositors and they allow banks to
hold efficient portfolios. However, if costly runs or markets for risky assets are introduced, central bank
intervention of the right kind can lead to a Pareto improvement in welfare.

Eliminating runs completely is an extreme policy that imposes costly constraints on the banking system.
Like-wise, laissez-faire can be shown to be optimal, but only under equally extreme conditions. In this
paper, we try to sort out the costs and benefits of runs and identify the elements of an optimal policy.

In this model, bank runs are an inevitable consequence of the standard deposit contract in a world with
aggregate uncertainty about asset returns. Furthermore, they play a useful role insofar as they allow the
banking system to share these risks among depositors. In certain circumstances, a banking system under
laissez-faire which is vulnerable to crises can actually achieve the first-best allocation of risk and
investment. In other circumstances, where crises are costly, we show that appropriate central bank
intervention can avoid the unnecessary costs of bank runs while continuing to allow runs to fulfill their
risk-sharing function. Finally, we consider the role of markets for the illiquid asset in providing liquidity
for the banking system. The introduction of asset markets leads to a Pareto reduction in welfare in the
laissez-faire case. Once again, though, central bank intervention allows the financial system to share
risks without incurring the costs of inefficient investment.

Financial crises can be optimal if the return to the safe asset is the same inside and outside the banking
system. The reason is that the optimal allocation of resources involves imposing some risk on people
who withdraw early. Allowing bank runs can be an efficient way of doing this. In this case, central-bank
and other government policies that eliminate runs lower the welfare of depositors. If the return to the
safe asset is higher within the banking system than outside, so that bank runs are costly, runs alone
cannot achieve the optimal allocation of risk. However, a monetary intervention by the central bank can
allow the first-best to be achieved.

Finally, if the risky asset can be sold in an asset market, bank runs may be costly even when the return
on the safe asset is the same inside and outside the banking system. Runs force the banks to liquidate
their assets when prospects are bad. Simultaneous liquidation drives asset prices down and allows
speculators in the asset market to profit. There is, in effect, negative insurance. Central bank
intervention that prevents the collapse in prices in the asset market can allow a Pareto improvement.
Bank Runs as an Equilibrium Phenomenon

The bank run is associated with a Prisoner's Dilemma-type situation in which the agents withdraw their
money from the bank not for consumption purposes but for reasons of self-interest. Our example has
what we consider to be several attractive features. First, there are no exogenous events on which agents
are conditioning their behavior, and, second, there is a unique equilibrium. The second feature implies
that, unlike the Diamond-Dybvig model, there are no equilibria without the possibility of bank runs.

The demand deposit contract we consider will not be optimal in general since it induces a Prisoner's
Dilemma-type situation for agents of types 1 and 2. One reason why standard demand deposit contracts
are not optimal in general is that superior contracts can be found that take the form of a contingent
demand contract. A contingent demand contract would be a contract in which, when an individual went
to the bank to withdraw money, the amount of money she would receive would depend on how many
other agents were attempting to withdraw money at the same time and how many were likely in the
near future to demand money back as well. A second reason, for which demand deposit contracts will
not be generally optimal, is that optimal contracts will typically have all agents bearing some of the risk
involved in the underlying investment decision.
Dynamic Debt Runs

Firms commonly spread out their debt expirations across time to reduce the liquidity risk generated by
large quantities of debt expiring at the same time. By doing so, they introduce a dynamic coordination
problem. In deciding whether to rollover his debt, each maturing creditor is concerned about the
rollover decisions of other creditors whose debt matures during his next contract period. We develop a
model with a time-varying firm fundamental and a staggered debt structure to analyze this problem. We
derive a unique threshold equilibrium, in which fear of a firm´s future rollover risk can lead to
preemptive runs. Our model characterizes fundamental volatility, asset illiquidity and debt maturity as
determinants of such dynamic runs.

A firm finances its long-term asset holding by rolling over short-term debt with a continuum of small
creditors. The firm uses a staggered debt structure, in which debt expirations are uniformly spread out
across time. This structure implies that the fraction of debt maturing in a short period is small. Thus,
each maturing creditor does not need to worry much about the rollover decisions of other maturing
creditors at the same time. However, he faces the risk that the firm could fail during his next contract
period if future maturing creditors choose not to roll over their debt contracts. Because of this so-called
rollover risk, he needs to coordinate his rollover decision with future maturing creditors. This dynamic
coordination problem is clearly relevant in practice and lies at the core of the model. This coordination
problem can lead to preemptive runs by creditors on a fundamentally healthy firm.

The model characterizes deteriorating fundamentals, asset illiquidity (rollover risk is an important
source of credit risk), fundamental volatility (when the firm´s fundamental volatility is sufficiently large,
creditors run on the firm even when its current liquidation value is sufficient to pay off its liability), and
debt maturity (maturity shortening can act as a self-enforcing tightening mechanism to push the firm
closer and closer to bankruptcy) as important determinants of such dynamic runs.

Diamond and Dybvig (1983) and others, is that bank runs are self-fulfilling prophecies. Given the
assumption of first-come, first-served, and costly liquidation of some assets, then there are multiple
equilibria. If everyone believes that a banking panic is about to occur, it is optimal for each individual to
try to withdraw his funds. Since each bank has insufficient liquid assets to meet all of its commitments, it
will have to liquidate some of its assets at a loss. Given first-come, first-served, those depositors who
with-draw initially will receive more than those who wait. On one hand, anticipating this, all depositors
have an incentive to withdraw immediately. On the other hand, if no one believes banking panic is
about, to occur; only those with immediate needs for liquidity will withdraw their funds. Assuming that
banks have sufficient liquid assets to meet these legitimate demands, there will be no panic. Which of
these two equilibriums occurs depends on extraneous variables or "sunspots." Although "sunspots"
have no effect on the real data of the economy, they affect depositors' beliefs in a way that turns out to
be self-fulfilling.