Banking, Liquidity and Bank Runs

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Banking, Liquidity and Bank Runs in an In…nite Horizon Economy Mark Gertler and Nobuhiro Kiyotaki NYU and Princeton University May 2012 Abstract We develop a variation of the macroeconomic model of banking in Gertler and Kiyotaki (GK2011) that allows for household liquidity risks and bank runs as in Diamond and Dybvig (DD1983). As in GK, because bank net worth ‡ uctuates with aggregate production, the spread in the expected rates of return on bank credit and deposit ‡ uctuates countercyclically. However, because bank assets have a longer maturity than deposits, bank runs are possible as in DD. Whether a bank run equilibrium exists depends on the condition of bank balance sheets and an equilibrium liquidation price for bank assets. Thus…show more content…
As in Gertler and Karadi (2011) and Gertler and Kiyotaki (2011), endogenous procyclical movements in bank balance sheets lead to countercyclical movements in the cost of bank credit. At the same time, due to maturity mismatch, bank runs may be possible, following Diamond and Dybvig (1983). Whether or not a bank run equilibrium exists will depend on two key factors: the condition of bank balance sheets and an endogenously determined liquidation price. Thus, a situation can arise where a bank run cannot occur in normal times, but where a severe recession can open up the possibility. Critical to the possibility of runs is that banks issues demandable short term debt. In our baseline model we simply assume this is the case. We then provide a stronger motivation for this scenario by introducing household liquidity risks, in the spirit of Diamond and Dybvig. Section 2 presents the model, including both a no-bank run and a bank run equilibria, along with the extension to the economy with household liquidity risks. Section 3 presents a number of illustrative numerical experiments. We illustrate how bank balance sheet behavior a¤ects the cost of credit in the no-bank run equilibrium and how it may open up the possibility of destructive bank run behavior. Finally, in section 4 we conclude with a discussion of policies that can reduce the likelihood of bank runs. As in Diamond and Dybvig, there is a role for deposit
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