Optimal Financial Crises

Authors

  • Franklin Allen,

    1. Wharton School of the University of Pennsylvania
    Search for more papers by this author
  • Douglas Gale

    1. Department of Economics at New York University
    Search for more papers by this author
    • Allen is from the Wharton School of the University of Pennsylvania and Gale is from the Department of Economics at New York University. The authors thank Charles Calomiris, Rafael Repullo, Neil Wallace, and participants at workshops and seminars at the Board of Governors of the Federal Reserve, Boston College, Carnegie Mellon, Columbia, Duke-University of North Carolina, European Institute of Business Administration, Federal Reserve Bank of Philadelphia, Instituto Tecnologico Autonomo de Mexico, University of Chicago, University of Maryland, University of Michigan, University of Minnesota, Nanzan University, New York University, the State University of New York, and the 1998 American Finance Association meetings. Financial support from the National Science Foundation, the C. V. Starr Center at New York University, and the Wharton Financial Institutions Center is gratefully acknowledged.

ABSTRACT

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.

Ancillary