The Effect of Safe Assets on Financial Fragility in a Bank-Run Model
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: bank runs, demand deposits, global games, liquidity provision, safe assets.
JEL classifications: D8, G21.
Suggested citation: Ahnert, Toni, and Mahmoud Elamin, 2014. “The Effect of Safe Assets on Financial Fragility in a Bank-Run Model,” Federal Reserve Bank of Cleveland, Working Paper no. 14-37.