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Demand–Deposit Contracts and the Probability of Bank Runs




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    • Goldstein is from the Wharton School, the University of Pennsylvania; Pauzner is from the Eitan Berglas School of Economics, Tel Aviv University. We thank Elhanan Helpman for numerous conversations, and an anonymous referee for detailed and constructive suggestions. We also thank Joshua Aizenman, Sudipto Bhattacharya, Eddie Dekel, Joseph Djivre, David Frankel, Simon Gervais, Zvi Hercowitz, Leonardo Leiderman, Nissan Liviatan, Stephen Morris, Assaf Razin, Hyun Song Shin, Ernst-Ludwig von Thadden, Dani Tsiddon, Oved Yosha, seminar participants at the Bank of Israel, Duke University, Hebrew University, Indian Statistical Institute (New-Delhi), London School of Economics, Northwestern University, Princeton University, Tel Aviv University, University of California at San Diego, University of Pennsylvania, and participants in The European Summer Symposium (Gerzensee (2000)), and the CFS conference on ‘Understanding Liquidity Risk’ (Frankfurt (2000)).


Diamond and Dybvig (1983) show that while demand–deposit contracts let banks provide liquidity, they expose them to panic-based bank runs. However, their model does not provide tools to derive the probability of the bank-run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic-based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand–deposit contract that trades off the benefits from liquidity against the costs of runs.