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Bank runs and the suspension of deposit convertibility

Article  in  Journal of Monetary Economics · November 1989


DOI: 10.1016/0304-3932(89)90031-7

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Journal of Monetary Economics 24 (1989) 443-454. North-Holland

BANK RUNS AND THE SUSPENSION OF


DEPOSIT CONVERTIBILITY

Merwan ENGINEER*
Unr~wrsr~v of Guelph, Guelph, 0n1 Canadu NIG -7WI

Received September 1988, final version received May 1989

In a longer-horizon version of Diamond and Dybvig’s (1983) model, suspending convertibrhty of


bank deposits into cash does not always prevent a bank run. A bank run may occur even if the
bank can adJust new wrthdrawal payments after observing too many withdrawals

1. Introduction

Diamond and Dybvig (1983) model a bank as a financial intermediary


which pools risk in an environment where privately observed consumption
shocks are uncorrelated across agents and longer-term productive assets earn
greater fixed rates of return than shorter-term assets. The pooling function
cannot be performed by insurance markets because contracts cannot be
conditioned on investors’ privately observed consumption shocks. Diamond
and Dybvig show that an efficient equilibrium exists if the bank employs a
standard demand deposit contract and aggregate consumption demand is
certain. However, they also show that there is a Pareto-inferior equilibrium
that might be described as a bank run. The bank-run equilibrium can be
eliminated by suspending convertibility after observing too many withdrawals.
A bank run also can be averted by suspending convertibility if aggregate
consumption demand is uncertain, but optimal risk sharing cannot be achieved
because some agents are prevented from withdrawing in the period they most
want to consume. This inadequacy of the suspension of convertibility moti-
vates government deposit insurance which supports the efficient equilibrium.
This paper examines a longer-horizon version of Diamond and Dybvig’s
model. In the extended model, suspending convertibility is less effective: it
may not eliminate the bank-run equilibrium. A run may occur even when the
bank can adjust new withdrawal payments after observing too many with-
drawals in a bank run.

*I am grateful to Dave Backus, Dan Bemhardt, Michael Hoy. Dave Nickerson. Dan Peled, and
an anonymous referee for their very helpful comments.

0304-3932/89/$3.500 1989, Elsevier Science Publishers B.V. (North-Holland)


444 M Engrneer, Bank runs and the suspensron ofdeposit converttbrlrty

In contrast, in the shorter-horizon (three-period) model with aggregate


consumption certainty, a bank run is averted simply by immediately suspend-
ing convertibility. The reasoning is straightforward. After the initial invest-
ment period 0, all agents discover their type in period 1. A proportion t’ of the
agents, called type 1 agents, experience a consumption shock in period 1 and
want to withdraw all their deposit and consume in that period. The remaining
agents, type 2 agents, want to consume only in period 2. They would normally
prefer to withdraw in period 2 than in period 1 (and hoard their money to
period 2) since the payment is higher in period 2. A bank run occurs when all
type 2 agents panic and attempt to withdraw in period 1 forcing the bank into
insolvency. Immediately suspending convertibility after 1’ withdrawals ensures
the solvency of the bank since no extra assets have to be prematurely
liquidated. More importantly, it assures type 2 agents that they can withdraw
in period 2. Since type 1 agents always attempt to withdraw in period 1, there
is no excess demand for withdrawals in period 2. Hence, type 2 agents never
panic and bank runs are prevented.’
Under the more realistic assumption that all agents do not discover their
type in period 1, bank runs may occur in a longer-horizon model. In this
paper, a four-period model is analyzed where type 2 and type 3 agents do not
discover their specific type until period 2.2 The immediate suspension of
convertibility after the proportion t’ withdrawals in period 1 and t* with-
drawals in period 2 ensures the solvency of the bank (where t2 is the
proportion of type 2 agents and t’ + t* < 1). Nevertheless, bank-run conjec-
tures are self-fulfilling. Nontype 1 agents run in period 1 out of fear that if
they turn out to be type 2 agents they will be in the bank queue when
convertibility is suspended in period 2. The excess demand for period 2
withdrawals comes from type 1 agents displaced in a run. So many type 1
agents are displaced in a run because some nontype 1 agents who turn out to
be type 3 agents withdrew in period 1. If type was known in period 1, all type
3 agents would wait to withdraw in period 3, leaving no excess demand for
period 2 withdrawals. The assumption that agents discover their own prefer-

’ For drfferent perspecttves on the suspensron of convertibility see Gorton (1985) and Char-i and
Jagannathan (1988).
“The reasons for a bank run in this model are quite different from those of Postlewaite and
Vives (1987) who also develop a four-period banking model. They model the strategic game
between two depositors, both of whom discover their type in period 1. If both agents turn out to
be type 2 agents a Prisoner’s Dilemma arises where each has a donunant strategy to withdraw in
period 1. This bank run occurs not because agents condition their behavior on an exogenous
sunspot but because aggregate preferences are uncertain.
In Bryant (1980) Chari and Jagannathan (1988). and Jacklin and Bhattacharya (1988) bank
runs occur because depositors receive information about the banks asset returns in the interim
penod. In Diamond and Dybvig and this paper bank runs occur in the absence of private
information about asset returns.
M. Engmeer. Bunk runs and the suspensron of deposit convertrhilq 445

ences over time is in the spirit of the banking analysis based on agents having
unknown liquidity demands.
A policy where the bank can freely liquidate assets and alter payments after
observing too many withdrawals in period 1 is also analyzed. The policy
involves offering a follow-up payment in period 1 that is attractive only to type
1 agents. If the remaining type 1 agents can be served cheaply in this way a
run is prevented. However, if type 1 agents value period 2 consumption
sufficiently highly, the follow-up payment must be large and bank runs cannot
be prevented.
The paper proceeds as follows. The model is outlined in section 2 and the
optimal risk sharing allocation is described in section 3. Section 4 briefly
analyzes the equilibria under the standard demand deposit contract. Section 5
demonstrates that the immediate suspension of convertibility does not elimi-
nate bank runs. A flexible payment policy designed to prevent bank runs is
developed in section 6. Finally, other institutions such as deposit insurance
and the exchange of dividend-paying shares are briefly examined in section 7.

2. The model

Diamond and Dybvig’s model is extended to four periods (T = 0,1,2,3) by


including an asset which matures in period 3 and also a third type of investor
who most wants to consume in period 3. All agents are endowed with one unit
of a storable homogeneous good in period T = 0. Any portion of the endow-
ment can be either stored for subsequent periods or invested at T = 0 in
productive assets. One unit invested in the short-term productive asset earns a
certain gross rate of return of S, .I 1 if liquidated in period 1. or a return of
S, > 1 if held to maturity in period 2. One unit invested in the long-term
productive asset yields L, < St, L, I S,. or L, 2 (S,)’ if liquidated in period
1, 2, or 3, respectively. In Diamond and Dybvig assets are liquid: S, = L, = 1
and S, = L,. When S, = L, = L, = 0, the assets are completely illiquid [for
example, Jacklin and Bhattacharya (1988) and Peare (1988)J.
The infinite population is divided into three preference types (i = 1,2,3)
according to the period in which they receive their major consumption shock:

Gpe 1

u(x:+e;x:+e:x:), 0< e;< l/S,, 0 c e: < e;s,p.,,


446 M Engrneer, Bunk runs und the suspemon of deposit convertrh1it.v

Type 3

where x+- is the amount of goods consumed by agent type i in period T,


P ’ s,-‘7 and u(x) is a twice differentiable, increasing, strictly concave func-
tion with relative risk aversion - xu”(x)/u’(x) > 1 everywhere. The weights
ei, #, and 0-j are chosen so that type 1 agents prefer to consume in period 1
most and in period 3 least; type 2 agents prefer to consume in period 2, and
type 3 agents only receive utility from consuming in period 3.3
In period 0, agents perceive their future type to be chosen randomly from
the infinite population, and have ex ante utility:

Eu = tb( X; + e;X; + e;X;) + t*p~(X; + e;X;) + i3( p)*U(Xi),

where t’, t’, and t3 = (1 - t’ - t2) are the known proportions of type 1, 2, and
3 agents. Agent type is private information. In period 1, type 1 agents discover
their type and types 2 and 3 learn they are nontype 1 agents; in period 2, type
2 and 3 agents discover their specific type. Unlike in the three-period model,
all agents do not discover their type at the same time.

3. The optimal allocation

The ex ante optimal risk-sharing allocation is described by the following


conditions:

l*=xl*= 2* =x2* = x3* =x3* = 0


X2 3 Xl 3 1 2 * 04

u’( xi*) = S*pu’( xi*) (lb)

tlxi* + t2(x:_*/S2) + t3(X:*/L3) = 1.


04

Type i agents only consume goods in period T = i. The restrictions on asset


yields and preferences are sufficient to ensure that L, > x3’* > x,2* > xi* > 1.
To achieve the optimal allocation, a: = t’x:* of the deposits is invested in the
storage technology, a2* = t*( x:*/S,) is invested in short-term asset and the
remainder in the long-term asset. Alternatively, if the long-term asset is liquid
all of the deposits may be invested in it.

3Dlamond and Dybvig do not explicitly model type 1 agents valuing penod 2 consumption. In
Wallace (1988) agents have a constant marginal rate of substitution in consumption between
periods much hke above.
M Engtneer, Bank runs and the suspensron of deposit concertdxlq 447

4. The bank equilibria under the demand deposit contract

The bank invests its deposits to achieve the optimal allocation. Under the
standard demand deposit contract, the bank promises to pay out cT = xF* to
any agent withdrawing his entire deposit in period T = 1,2. Agents that
attempt to withdraw in a particular period arrive in the bank line in random
order and are served sequentially. If the bank faces a shortage of funds to
service withdrawals in either period 1 or 2, it allocates on a first come, first
serve basis. In this case some demanders are left with nothing in the period
that they most want to consume. In the last period the bank is liquidated and
the remaining depositors receive their pro rata share of any remaining assets.4
The efficient bank equilibrium emerges when all active deposit holders
believe that other agents intend to withdraw their deposits only in the period
that they most want to consume, ck = x;* for T = i and ck = 0 for T # i. With
these beliefs, the best response of any agent is to withdraw his deposit in the
period which he most wants to consume. At no stage does the bank have to
prematurely liquidate productive assets to service withdrawal demands.
There also is a Pareto-inferior bank-run equilibrium. Suppose all agents in
period 1 believe that other investors are going to attempt to withdraw in
period 1. If an investor attempts to withdraw his deposit, he is successful with
probability ( CX: + cy:S, + cu:L,)/x:* < 1. On the other hand, if he does not
attempt to withdraw his money, all of the bank’s assets are liquidated and
distributed in period 1 leaving him with nothing. For this reason all deposit
holders participate in the bank run when they believe others also are going to
run.

5. A bank run with the immediate suspension of convertibility

To prevent the premature liquidation of productive assets, the bank can


suspend deposit convertibility when faced with excess withdrawal demands.
This is sufficient to avert bank runs in the three-period model.5 In this model,
the immediate suspension of convertibility after t’ withdrawals in period 1
and t’ withdrawals in period 2 prevents the premature sale of assets, but as
the following proposition shows it is not sufficient to prevent a bank run.

4Bank runs are harder to avert if the bank contract ts c-I = xF* to any agent who wtthdraws hts
deposit m period i- = 1.2.3 as long as funds last.
‘In the three-penod model, declaring bankruptcy to prevent the value destroymg sale of assets
in period 1, with the legal proceedings m period 2, has the same effect as tmmediately suspending
convertibility and, therefore, also averts a run Note that wrth completely illiqmd assets. the bank
has no chorce but to declare bankruptcy when faced with too many withdrawals m period 1 Thus,
the three-period model suggests paradoxtcally that banks, if they have the choice, should Invest m
completely illiqmd rather than liquid assets to precommit and avoid the bad equilibnum.
448 M. Engineer, Bank runs and the swpens~on of deposrt conuertlbdq

Proposition. With the immediate suspension of convertibility after t’ with-


drawals in period 1 and t2 withdrawals in period 2, a bank-run equilibrium exists
if the expected utility of a nontype I agent withdrawing in period 1 is greater than
not withdrawing,

(t” + pt3)
PU( x:*> ’ 2,
1 - t’

where

tlt3
u(x22*) + mP+,zx:*)

+ &JPMX:.)I.
The equilibrium is characterized by all agents queuing for withdrawals in period 1
and the following rationed proportions of agents of each type withdrawing
c$ = XT’* in period T:

Period ( T)
Type (i> 1 2 3

t’t2 t3( ty2


1 (t’)Z -
1 - t3 l-t3

2 et2
(t’)’ t’t2t3
l-t3 l-t3

3 t’t3 0 P(l -t’)

Proof. In period 7, type 1 agents have a dominant strategy to attempt to


withdraw their deposits. Suppose all nontype 1 agents believe that all other
agents are going to attempt to withdraw their deposits in period 1. If a
nontype 1 agent queues to withdraw his deposit, he receives xi* with proba-
bility t’. If he is successful in withdrawing his funds, his expected utility in
period 1 is

t*
yqy+4*) =“f’:f3’
+ -&p)*u(x;*) p+:*>

If he fails, he is in the same position as if he did not queue. The proportion t1


M. Engineer, Bank runs and the suspensron of deposit convertrbd~ty 449

of each type receive xi‘* , leaving 1 - t’ of each type with remaining claims
under the bank-run scenario. In period 2, type 2 and 3 agents discover their
type. Now the remaining type 1 and 2 agents have a dominant strategy to
queue in period 2. Together they constitute the proportion (t’ + t’)(l - rl) =
t2 + t’t3 of the population. The bank distributes xi* to t2 agents in period 2,
bumping the remaining t1t3 agents to period 3. Since there is no excess
demand for deposits in period 3 [t’t3 + (1 - t’)t3 = t3], all the remaining
agents receive x33*. A nontype 1 agent p articipates in the bank run in period 1,
if his expected utility is greater than waiting to withdraw in later periods:

( t2 + pf3) (t’ + pt3)


t’ pu(xi*)+(l-t’)Z>Z or pz+;*> >z.
1 - t’ 1 - t’

If this condition is satisfied and all nontype 1 agents believe that all other
agents are going to run in period 1, they also run. The proportions of agents of
each type that are able to withdraw is straightforwardly derived from the
above sequence. n

Bank-run conjectures are self-fulfilling because each nontype 1 agent fears


that if he turns out to be a type 2 agent he may be one of the t1t3 unserved
agents in line when convertibility is suspended in period 2. By joining in a run
in period 1, a nontype 1 agent can reduce the probability of being a cashless
type 2 agent in period 2 by the factor t’. It is optimal for a nontype 1 agent to
run in period 1 (when all other agents run) if a type 2 agent’s utility of being
cashless in period 2 and consuming in period 3 is sufficiently low. Accordingly,
the condition for a bank-run equilibrium is satisfied if t’, t2,t3 > 0 and
u( 0:x:* ) is small enough.
For example, let t’ = t 2 = t3 = i and U(X) = - l/x. A nontype 1 agent who
chooses not to run in period 1 has a + chance of being a type 2 agent who is
not served in period 2. In contrast, a nontype 1 agent who runs in period 1 has
a & chance of being a type 2 agent who is not served in period 2. The relative
importance of consuming in period 2 over period 3 depends on 6):. As 13: + 0,
u( 0:x:*) -+ - cc, and the proposition is satisfied.
A bank-run equilibrium is more likely to exist the smaller is the difference
between the optimal payments, because the relative gain to a nontype 1 agent
successfully withdrawing in the period of his consumption shock becomes
smaller. In fact, as x22* and x:* approach xi*, the relative gain to success-
fully withdrawing later goes to zero and the condition for a bank-run equilib-
rium is satisfied. Examples where close optimal payments lead to bank runs
are analyzed in the next section.
A bank run depends on type 2 and 3 agents not knowing their type in
period 1. The t’f3 excess demands for period 2 withdrawals originate from the
t’t3 type 3 agents who successfully withdrew in period 1 when they did not
450 M. Engmeer, Bunk runs and the suspension of deposit convertrbility

know their identity. If type 3 agents knew their type in period 1 they would
not run, because they are assured that they can withdraw more in period 3.
But then there is no excess demand for period 2 withdrawals and type 2 agents
are better off withdrawing in period 2 than running in period 1. It is because
all agents discover their type in period 1 in the three-period model that there is
no bank-run equilibrium with the suspension of convertibility. The assumption
that agents’ preferences are revealed over time is in the spirit of banking
analysis based on agents having unknown liquidity demands.
Also, a bank-run equilibrium does not exist if type 1 agents prefer to
consume in period 3 over period 2, 04 > O:S,/L,. With such preferences, there
is no excess demand for period 2 withdrawals, because if there were, there
would be an excess supply of period 3 payments (at rate x: * ) and type 1 and
3 agents could do better by withdrawing in period 3. Hence, nontype 1 agents
wait until period 2 to discover their specific type and no bank run occurs.
Nontype 1 agents face a greater temptation to participate in a bank run if
withdrawals can be reinvested in period 1 in a newly created bank. This bank
is assumed to be able to buy a two-period productive asset in period 1 that has
a gross rate of return S’ > 1 in period 3. The original bank is only viable if
nontype 1 agents are no worse off keeping their money in the old bank when
there is no run in period 1:

tsP44*)+;r;-fit3 ( p)*u(x;*)
t2
t2+
t2
’- ,,,,,PG) + gp~P~‘4~:),

where 2: and 22 are the solutions to the three-period optimal risk-sharing


problem starting in period 1 with deposits of x:* per capita. (Starting in
period 1, both banks have a three-period horizon so that the immediate
suspension of convertibility precludes runs.) Let S” be the rate of return the
new bank earns that makes nontype 1 agents indifferent between the above
alternatives.
A bank-run equilibrium exists if nontype 1 agents receive more utility
switching banks in the event of a run:

t2+
t2
GP43) + t2
*3 ( p )‘2.4($) >z.

This condition is always satisfied for S’ sufficiently close to S” (from below). If


S’ > S”, optimal payments must be abandoned by the original bank. If they
reduce the first-period payment just enough to satisfy the incentive compatibil-
ity condition, a bank-run equilibrium exists.
M. Engrneer, Bank runs and the suspension of depositconvertiblht) 451

6. A flexible payment policy

This section considers a policy which allows the bank to liquidate assets and
alter payments in a bank run after having observed too many withdrawals
(f > t’ withdrawals) in period 1. To simplify the analysis, the long-run asset is
assumed to be perfectly liquid so that the bank invests all its deposits in the
long-run asset in period 0. Also, 63’ and 0: are assumed to be arbitrarily small
so that type 1 and 2 agents always prefer to consume in period 2 over period 3.
After t’ withdrawals of xi* in period 1, the bank can either suspend
convertibility or liquidate more assets to serve additional agents in period 1.
Suppose the bank liquidates assets in a bank run to serve additional agents in
period 1. Since type is not observable, it is optimal to pay the additional
withdrawers in period 1 the same payments xi. The bank should offer a low
payment xi to separate and cheaply serve the remaining type 1 agents in
period 1. A necessary condition for type 1 agents to accept such a payment is
xi 2 8:x,. Therefore, the bank sets xi = @x,. As 0: < l/S,, the strategy of
separating type 1 agents leaves more assets per capita for nontype 1 agents
withdrawing in later periods. Therefore, this policy dominates the policy of
suspending convertibility in period 1.
Under the separation policy the program to maximize the expected utility of
the remaining nontype 1 agents in period 1 is

max L(r2~(~2) +pt3u(x,)),


x2.x3 1 - t’
subject to

(1 - tyx, + (1 - t’)t’x,
I - tlx;* - (1 - tl)tle:x2 =
s, L, ’

A nontype 1 agent is made better off by running when all others run if

(t2 + pt3)
pu(x:*) ’ $-+(Pu(P,) + Pf3d~3)),
1 - t1

where Zz and g2, solve (P).


An example that satisfies the condition for a bank-run equilibrium is the
following: L, = 1, L, = S, = 4, L, = 1.8, t’ = t2 = t3 = $, p = 0.76 u(x) =
-l/x, and 6: = 0.735. In this example, the differences between the optimal
allocations are small: xi* = 1.292, x2** = 1.301, and xi* = 1.318. In addition,
period 2 consumption is a close substitute to period 1 consumption for type 1
agents. The best the bank can do is set Zi = 0.821, P, = 1.125, and I, = 1.603.
The period 2 payment is low in order to reduce the period 1 separation
payment. Nevertheless, a bank-run equilibrium exists in this case.
452 M. Engineer, Bank runs and the suspensmn of deposrr convertibd~<l:

With perfectly liquid assets and a flexible payment policy other examples
where bank runs cannot be prevented share similar features. The differences
between the optimal payments is small. Thus, xi* is relatively large and a
temptation to period 1 runners. The large period 1 payments reduce the assets
available for later periods. The other feature is that 0: is large.6 This means
the bank cannot cheaply separate and serve the remaining type 1 agents in
period 1. If restrictions are put on policy or assets are illiquid, the condition
for the bank-run equilibrium becomes less restrictive. For example the condi-
tion in Proposition 1 is the best policy for preventing a run when assets are
illiquid and payments are inflexible.
Finally, note that if the bank can anticipate a bank run and alter payments
to all agents including the first t’ agents, a run may be averted. For instance,
in Bental, Eckstein, and Peled (1989) and Freeman (1988) a bank run is
explicitly modelled as a ‘sunspot equilibrium’. Runs in these papers can be
prevented because the bank can observe and condition payments on the
sunspot. However, such a policy does not achieve optimal risk sharing,
because type 1 agents receive too little in period 1.

7. Other institutions

In this model, government deposit insurance, similar to the type found in


Diamond and Dybvig, can prevent all bank runs and achieve the optimal
allocation. If f > t’ agents queue in period 1, the bank can serve all the queued
agents xi* without prematurely liquidating assets by drawing ‘deposit insur-
ance’. The deposit insurance can be paid by levying a tax on period
1 withdrawers. If f > t’, all agents withdrawing in period 1 are taxed
(1 - t’/f )xi*, leaving each with (t’/f )xi* after tax. The capacity of deposit
insurance to alter withdrawals ex post effectively bypasses the sequential
service constraint. A nontype 1 agent never runs because he knows that there
is no excess demand for period 2 withdrawals. Hence deposit insurance
achieves the optimal allocation when there is uncertain individual liquidity
demands in period 1.
Diamond and Dybvig show that even with uncertain aggregate consumption
demands deposit insurance can achieve the full-information, optimal risk-shar-

6There is a tradeoff between 0: and x i* to satisfy the condition for a bank-run equilibrium.
This tradeoff can be reduced by increasing the concavity of U(X). For example, if u(x) =
-1/(2x2), a smaller first-period payment x1I* -- 1 290 is consistent with a smaller substitutton
coefficient 0: = 0.12.
‘Taxes can be pard wtth deposits. Diamond and Dybvig constder a scheme where the tax does
not always cover the entire amount of the excess withdrawals and some assets are liquidated
prematurely. The altemattve mechanism considered here works even if assets are completely
illiquid.
M. Engrneer, Bank runs and the suspensron of deposit convertibility 453

ing allocation. However, Wallace (1988) argues that government deposit


insurance cannot achieve optimal risk sharing if the implicit assumption that
agents are isolated is added to the model.* In the model studied here two other
potential problems arise when there is aggregate uncertainty. First, if the
long-term asset is illiquid, the optimal allocation requires that the bank invest
some of the deposits in the assets of shorter duration. The exact amount
depends on the realized aggregate demands. But since this is unknown in
period 0, the optimal allocation cannot be achieved generally without an
infusion of external funds.
Second, if the aggregate uncertainty is not resolved in period 1, there is not
enough information in the economy to calculate the full-information optimal
allocation. For example, suppose u(x) = -l/x. Then in the four-period
model the full-information allocation xi* = l/[t’ + t2(~/S2)1/2 + t’p/L\“] is
a function of the actual population proportions t’, t*, and t3. Thus, x:* can
take on different values for a given 1’ depending on t2 and t3, where
t2 + t3 = 1 - t’. Thus, even if the bank could infer t’ from the number of
withdrawals in period 1, it cannot determine xi* with certainty when t 2 and
t3 are unknown in period 1.9
Finally, it should be noted that bank deposits may not be the only way of
achieving the optimal allocation. Jacklin (1987) shows, using Diamond and
Dybvig’s preferences, that the optimal allocation can be achieved by the
market exchange of dividend-paying equity. This result generalizes to this
model, even though all agents do not know their specific type in period 1. In
period 0 each agent buys one share with his endowment. The firm invests the
endowment and promises to pay dividends D’ = t’x:*, D2 = t ‘x22*, and
D3 = t3X,3* in periods 1, 2, and 3, respectively. Suppose that in period 1
nontype 1 agents exchange all their dividends for all the shares of the type 1
agents, and in period 2 type 3 agents exchange all their dividends for all the
shares of type 2 agents. Thus, each type 1 agent receives xi* and each nontype
1 agent has l/(1 - t’) shares entering period 2. In period 2, each type 2 agent
receives xi* and each type 3 agent has l/(1 -t’) + t2/t3(1 - t’) = l/t3
shares entering period 3. The dividends to each type 3 therefore are xi*. With
these exchanges, share prices in periods 1 and 2 are, respectively, 1 - t’xi*
and t3xz*. At these prices no agent has an incentive to deviate. Type 2 agents
prefer t3xf* per share in period 2 to t3x: * in period 3, and type 3 agents
prefer the opposite. Type 1 agents prefer (1 - t’)x:* per share in period 1 to
the most they can obtain in later periods: (1 - t’).xz* in period 2 or (1 - t’)x:*

“Without the isolation of agents a credit market may exist. Jacklin (1987) shows that a credit
market is inconsistent with bank deposits that provides liquidity.
91n the three-period model, r2 = 1 - ti. Thus, if t1 can be determined, x:* can be calculated.
Diamond and Dybvig use deposit insurance to face agents with payoffs such that they have a
dominant strategy to withdraw only in the period of their consumption shock. Thus, t1 is inferred.
454 M. Engineer, Bank runs and the suspemon of deposit convertibrht~

in period 3. Nontype 1 agents prefer the opposite in period 1. Thus, the


exchange of ex-dividend shares achieves the optimal allocation.”

References
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equilibrium, Journal of Finance 63, 749-763.
Diamond, D. and P. Dybvig. 1983, Bank runs, deposit insurance, and liquidity, Journal of
Political Economy 91, 401-419.
Freeman, Scott, 1988. Bankmg as the provision of liquidity, Journal of Business 61, 45-64.
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“Jacklin pomts out that with more general ‘smooth’ preferences (such that each agent receives
optimal payments in more than one period) that the exchange of ex-dividend shares generally
cannot achieve the optimal allocation whereas complex demand deposit contracts can.

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