Working Paper

The Effect of Safe Assets on Financial Fragility in a Bank-Run Model

Abstract: Risk-averse investors induce competitive intermediaries to hold safe assets, thereby lowering the probability of a run and reducing financial fragility. We revisit Goldstein and Pauzner (2005), who obtain a unique equilibrium in the banking model of Diamond and Dybvig (1983) by introducing risky investment and noisy private signals. We show that, in the optimal demand-deposit contract subject to sequential service, banks hold safe assets to insure investors against investment risk. Consequently, fewer investors withdraw prematurely, which reduces the probability of a bank run. Safe asset holdings increase investor welfare and may increase the bank?s provision of liquidity.

Keywords: liquidity provision; global games; demand deposits; safe assets.; bank runs;

JEL Classification: D8; G21;

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Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2014-12-22

Number: 1437

Pages: 51 pages