BANK RUNS - LIQUIDITY COSTS AND INVESTMENT DISTORTIONS

In this paper we extend the Diamond and Dybvig (1983) model of interme diation to study further the conditions under which bank runs can occu r and to consider how private parties might adjust to the existence of bank-run equilibria. We provide weaker necessary conditions for runs, We then characterize how banks respond to the possibility of runs in their design of deposit contracts and investment decisions. Banks migh t choose to offer contracts that prevent runs, but under some conditio ns the (second) best contracts will involve accepting some risk of run s in order to achieve higher expected returns from their investments. (C) 1998 Elsevier Science B.V. All rights reserved.