Bank Runs and Institutions: The Perils of Intervention

Huberto M. Ennis and Todd Keister

Presented by Resem Makan & Sulagna Dasgupta

November 24, 2017

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Overview

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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Central question of the paper

A widespread bank run invariably triggers interventions by the

government and/or central bank. Two key features:
1 Deposit freezes
2 Payment rescheduling:
Conversion to term deposits
Need-based access to funds
Central question studied in this paper: Is the wave of withdrawals
during a banking crises reflects, at least in part, self-fulfilling behavior?

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Ex-post efficient policy interventions

What is an ex-post efficient intervention?

A policy response which maximizes aggregate utility in the run
scenario
Traditionally studied policy responses have not been ex-post efficient
If a run started and reached the point where deposits are to be frozen,
a benevolent banking authority would not want to follow through with
the freeze.
Institutional features often prevent policymakers from being able to
precommit to follow a particular course of action in the event of a
crisis.
Due to the aforementioned reason, a banking authority that is unable
to precommit to follow the complete-freeze policy would not choose
to do so once a run is underway.

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Ex-post efficient interventions may trigger self-fulfilling
runs

Figure 1: Ex-post efficient interventions may trigger self-fulfilling runs

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The trade-off between efficiency and run-prevention roles
of policy responses

The central time-inconsistency problem in banking policy

Banking authorities would like depositors to believe they will be tough
in response to a run.
However, if a run were to actually start, the authorities would not find
it optimal to take a tough stand.
Instead, they would choose a more lenient policy, and this policy can
end up justifying the original decision of depositors to run.

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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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The Model
A. Preferences
Three time periods, t = 0, 1, 2.
There is a continuum of ex-ante identical depositors with measure
one. Each depositor has preferences given by:

v(c1 , c2 ; θ) = u(c1 + θc2 )

u(.) strictly increasing, strictly concave, satisfies u(0) = 0, u0 (0) = ∞
ct = consumption in period t
θ = a binomial random variable with support {0, 1}
If the realized value of θ is zero, the depositor is impatient and cares
only about consumption in period 1.
P r(θ = 0) = π, i.e. π = the probability with which each individual
depositor will be impatient. π is non-stochastic; no aggregate
uncertainty.
A depositors type (patient or impatient) is private information and is
revealed to her at the beginning of period 1
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The Model

B. Endowments
The economy is endowed with one unit of the consumption good per
capita in period 0. There are two constant-returns-to-scale
technologies for transforming this endowment into consumption in the
later periods. A unit of the good placed into storage in period 0 yields
one unit of the good in either period 1 or period 2.
A unit placed into investment in period 0 yields either R > 1 in period
2 or (1 − τ ) in period 1, where τ ∈ (0, 1) represents a liquidation cost.
Therefore, investment offers a higher long-term return than storage
but is relatively illiquid in the short term.

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The Model

C. The banking system

Depositors pool resources to form a bank which allows them to insure
against individual liquidity risk and minimize costly liquidation.
There is a benevolent banking authority (BA), which has the power to
freeze deposits in period 1 if it deems that doing so would increase
the welfare of depositors (ex-post efficiency).
In the scenario where there is payment rescheduling post-run, there is
a court system that can, once a deposit freeze has been declared,
verify depositors types and reschedule payments.

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The Model
D. The timing of the events
Before beginning of the analysis all endowments deposited in the
bank.
In period 0, the bank divides these resources between storage and
investment.
In period 1, depositors are isolated from each other and no trade can
occur.
Depositors can, however, contact the bank in period 1 and, hence, the
bank is able to make payments to depositors from the pooled
resources after types have been realized.
Upon learning their type, each depositor has the opportunity to either
contact the bank in period 1 or wait and contact the bank in period 2.
Those depositors who contact the bank in period 1 do so in a
randomly assigned order.

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The Model

E. Sequential service constraint

Assumption: Impatient depositors must consume immediately after
contacting the bank in period 1.
This sequential-service constraint implies that the payment made to
such a depositor can be contingent only on the number of
withdrawals that have occurred so far and not on the total number of
withdrawals in the period, which has not yet been observed.
The constraint captures an essential feature of banking: the banking
system pays depositors as they arrive and cannot condition current
payments to depositors on future information. We assume that
the BA and the courts are also subject to the sequential-service
constraint. Hence, for example, a deposit freeze can apply only to
funds that have not yet been withdrawn; it cannot be made
retroactive.

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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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First Best Allocation

Suppose we introduce a benevolent planner who can observe

depositor types and assigns allocations based on types it observes.
The first best allocation thus is where the planner allocates
consumption to impatient types only in period 1 and to patient types
only in period 2.
Let cE denote the amount given to impatient depositors (who
consume early) and cL the amount given to patient depositors (who
consume late).
Let i denote the fraction of the total endowment placed into
investment; the remaining 1−i would go into storage.

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First Best Allocation contd.
Then the planner would choose cE , cL , and i to solve

maximize πu(cE ) + (1 − π)u(cL )

cL ,cE ,i
1−i
subject to cE = ,
π
Ri (1)
cL = ,
1−π
cE , cL ≥ 0,
0≤i≤1

Let (c∗E , c∗L , i∗ ) denote the solution to this problem, which is

characterized by the condition

u0 (c∗E ) = Ru0 (c∗L )

∴ c∗L > c∗E .
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Condition for bank run to arise

Assumption 3.1
c∗E > 1 − τ i∗

In order for the possibility of a bank run to arise, the aforementioned

condition must be satisfied.
This condition implies that the first-best allocation is greater than the
per-capita liquidation value of all assets in period 1. Thus the
planner’s allocation provides liquidity insurance to the depositors.

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The case for CRRA Utility

c1−γ
u(c) = (2)
1−γ
1
c∗E = (3)
π + (1 − π)R(1−γ)/γ

R1/γ
c∗L =
π + (1 − π)R(1−γ)/γ

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Which Equilibrium?

There are 2 possible equilibria that could arise.

Suppose the banks sets its investment at i∗ and sets the early
payments to c∗E . Clearly, all the impatient depositors would choose to
withdraw early and obtain c∗E . For an impatient depositor, if he
believes that all the other patient depositors will withdraw later, his
best response is also to postpone withdrawal since he will then receive
c∗L > c∗E .
Another equilibrium is where a patient depositors believes that the
other patient depositors are withdrawing early and hence his best
response is to withdraw early as well instead of running the possibility
of getting 0 in round 2 when the bank will run out of money by then.
We say that the banking system is fragile if this type of run
equilibrium exists when the period-1 payment on demand deposits is
set at c∗E .

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Proposition 1: Deposit freeze to prevent run

Proposition 1
If deposits are frozen after π withdrawals in period 1, the banking system
is not fragile.

Reason:
If a patient depositor believes the BA will freeze deposits after π
withdrawals in period 1, then she is sure the bank will have enough
resources to pay at least c∗L in period 2.
Since c∗L > c∗E holds, waiting to withdraw is a strictly dominant
strategy for her, and the only equilibrium has all patient depositors
withdrawing in period 2.

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Proposition 1: Deposit freeze to prevent run

However, in reality, deposit freezes take place slightly differently.

First, the freeze is usually declared relatively late in the course of the
overall crisis. Figure 1 presents the evolution of total bank deposits in
Argentina during the crisis of 2001-02. From their peak on February
28, 2001, total deposits had fallen 21.8 percent by the time the freeze
was declared on December 1, 2001.
Second, deposits are often not frozen completely; some types of
withdrawals may still be allowed. In Argentina, for example, during
the freeze announced on December 1, 2001, depositors were allowed
to withdraw up to 1,000 pesos per month from each account.

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Evolution of deposits during the Argentinian crisis 2001-02

Figure 2: Evolution of deposits during the crisis in Argentina 2001-02

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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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Deposit freeze: Central questions

The main objective is to understand:

When should a benevolent banking authority declare a deposit freeze?
How this ex post decision, in turn, affects the ex ante incentives of
depositors to participate in a run?

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Choosing when to freeze
When should the BA freeze?
Consider a situation where the bank has already paid out c∗E to a
fraction π of depositors. Suppose there is a further withdrawal of
deposits beyond this point at Period 1, it means that the patient
depositors are withdrawing as well and a case of a run must be
underway.
It then realizes that some of the funds already paid out were given to
depositors who are actually patient, and that some impatient
depositors have not yet been served. Freezing deposits immediately
implies giving nothing to the remaining impatient depositors, which
may be very costly from a social point of view.
We now investigate the problem that a benevolent banking authority
faces in deciding when to declare a deposit freeze, and how this ex
post decision, in turn, affects the ex ante incentives of depositors to
participate in a run.
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What should the BA do under such a run?

Let πs denote the freeze point, that is, the fraction of depositors the
BA would choose to serve before freezing deposits when faced with a
run.
Then the BA would seek to maximize depositor welfare by solving the
following problem:
max W (πs ) ≡ πs u(c∗E ) + (1 − πs )(1 − π)u[cL (πs ) (4)
πs

subject to,
R
1−τ (1− τ i∗ − πs c∗E )
cL (πs ) = (5)
(1 − π)(1 − πs )
π ≤ πs ≤ πsU
where πsU is the maximum proportion of depositors that can be paid c∗E in
period 1, that is, πsU = (1 − τ i∗ )/c∗E .

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What should the BA do under such a run? Continued.

The objective (4) states that a fraction πs of depositors will be served

in period 1, and each will receive c∗E . Of the remaining 1 − πs
depositors, only a fraction 1 − π will be patient and return in period
2. The other π will be impatient and will receive nothing, leaving
them with a utility level of zero.
The function cL (πs ) in (5) represents the consumption of patient
depositors who are forced by the freeze to return in period 2;
The numerator equals the total resources of the bank in period 2.
The denominator is the mass of patient depositors who were not
served in period 1.
The second constraint reflects both sequential service and feasibility:
the BA discovers that a run is underway only after π withdrawals
have been made, and it runs out of funds after serving πsU depositors.

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What should the BA do under such a run? Continued.

Also note that,

0 R
cL (πs ) = (1 − τ i∗ − c∗E ) < 0
(1 − τ )(1 − π)(1 − πs )2

This holds from Assumption 1 (1 − τ i∗ < c∗E ). It then clearly follows

00
that cL (πs ) is also negative. So cL (πs ) is strictly concave.
Given that the utility function is concave, there exists a unique
solution to the maximization problem which we denote πsM . Note
that the BA faces a trade-off in choosing when to freeze. If the freeze
is delayed, some impatient depositors will be able to consume c∗E
instead of 0 in period 1. But that reduces the amount the remaining
patient depositors will get in Period 2.
Additionally, the patient depositors consuming c∗E can do better by
waiting till period 2.

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Period 2 payoff is a decreasing, concave function of freeze
point

Figure 3: Period 2 payoff after a deposit freeze at πs

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No run condition on freeze-point

Lemma 1
There exists a value π T > π such that for all freeze points πs ∈ [π, π T ),
the banking system is not fragile.

Lemma 1 is analogous to the similar DD result.

If πsM < π T , depositors anticipate that the BA will impose the freeze
relatively quickly and, since πsM > c∗E holds, a patient depositor is
better off waiting than participating in the run.
However, if πsM > π T , depositors expect the BA to impose the freeze
relatively late. This causes them to rush for their deposits as early as
possible since there is a possibility they will get 0 in period 2 if they
are not in time. A patient depositor who expects others to run will,
therefore, choose to run as well and a self-fulfilling bank run can arise.

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Proposition 2: Beyond an upper bound for proportion of
impatient agents, fragility ensues

Proposition 2
Under the (ex post) efficient deposit freeze, the banking system is fragile if
and only if,
0
u (c∗E )c∗E
 
R
π− − (1 − π) ≥ 0 (6)
u(c∗E ) 1−τ

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Proposition 2: Beyond an upper bound for proportion of
impatient agents, fragility ensues

For the CRRA utility function in (2) with γ ∈ (0, 1),

  
1−γ R
π− −1 ≥0 (7)
γ 1−τ

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Proposition 2: Sufficient conditions for fragility and
non-fragility

1 The system is never fragile if,

 
1−τ
γ < 1− (8)
R
2 For γ < 1, the system is fragile for any given values of π, R and τ if,

γ → 1−

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High risk aversion leads to fragility

Corollary 1
Under (2) or (9) and the ex post efficient deposit freeze, the banking
system is fragile if depositors are sufficiently risk averse.

For γ ≥ 1, we use the following utility function since (2) no longer

satisfies u(0) = 0.

(c + b)1−γ − b1−γ
u(c) = (9)
1−γ
The coefficient of relative risk aversion is not constant, but for any
level of c it converges to γ as b goes to 0.
When γ > 1 (and b ≈ 0), the banking system is fragile for any value
of π

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Fragility: Run may occur, but will it occur?

Whether run will occur is driven by realization of an extrinsic sunspot

variable.
Hence the exogenous run probability (i.e. distribution of the sunspot
variable) is known (say, ps ). Therefore the payment offered by the
bank in period 1 may depend on this probability.
cE << c∗E in period 1 to convince
If ps is high, banks may offer b
depositors not to run. (”run proof”-ing)
Run-proof contracts: Liquidity insurance is low, hence, have
substantially lower aggregate expected utility than in the first-best
allocation.
Hence, if ps is small, choosing a run-proof contract is not optimal

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Policy responses to fragility create distortions in the
economy
Two main takeaways:
1 The banking system is fragile ⇒ an equilibrium can be constructed in
which a run occurs with positive probability and all contracting and
deposit decisions take this probability into account.
2 The ex ante possibility of a run will lead banks to choose a period-1
payment different from c∗E , so that the first-best allocation does not
obtain even in states where a run/freeze does not occur.
Contrast with DD:
In this setting, the run equilibrium (in case of fragility) will include a
deposit freeze in states where a run occurs.
This contrasts sharply with DD, where the threat of a deposit freeze
eliminates the possibility of a run and, hence, a deposit freeze never
occurs (This is because in the DD model intervention is not ex-post
efficient).
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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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Payment rescheduling: Central questions

The main objective is to understand:

What are the ex-post efficient ways to reschedule payments?
What are the ex-ante incentives that this policy reaction gives to
depositors?

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The motivation behind payment rescheduling

After a run is identified, it would be socially optimal to combine the

deposit freeze with some degree of payment rescheduling.
If the BA can sort depositors by type it can allow only those who are
truly impatient to withdraw in period 1.
In this case it would be optimal to reduce, if possible, the payment
given to the post-run identified impatient depositors below c∗E in
order to economize on costly asset liquidation.
During the Argentinian crisis of 2001, depositors claiming to have
urgent financial needs (illness, hospitalization) were allowed to file a
legal recourse requesting withdrawal of some or all of their funds from
the banking system while the freeze was in place. (≈ 200,000 cases
were filed, 14 Bn pesos awarded)
Along the same lines, the authors model the case where post-run,
types can be verified by BA involving the court system.

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Bank’s optimization problem in the run scenario with court
intervention

Assumption 5.1
Type verification by courts is costless.

Assumption 5.2
Type verification can occur only after at least π depositors have already
withdrawn and the BA has declared a deposit freeze.

Without Assumption 5.2, costless type verification by courts can be

used to completely overcome the private information problem.

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Bank’s optimization problem in the run scenario with court
intervention
This payment is chosen to solve the following problem:

maximize (1 − π)[πu(cE ) + (1 − π)u(cL )]

cL ,cE
subject to (1 − π)πcE ≤ (1 − τ )i∗ ,
(1 − π)πcE
(1 − π)2 cL = R[i∗ − ],
(1 − τ )
cE ≥ 0,
cL ≥ 0

Let (c∗ER , c∗LR ) denote the solution to the problem, which is

characterized by the condition

0 R 0 ∗
u (c∗ER ) = u (cLR )
1−τ
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Proposition 3: Condition for fragility under payment
rescheduling
Proposition 3
Under a deposit freeze followed by court intervention the banking system
is fragile if and only if c∗E ≥ c∗LR

Rescheduled payments in the CRRA case:

1 (1 − τ )i∗
c∗ER =
π + (1 − π)[R/(1 − τ )](1−γ)/γ (1 − π)
(10)
[R/(1 − τ )]1/γ (1 − τ )i∗
c∗LR =
π + (1 − π)[R/(1 − τ )](1−γ)/γ (1 − π)
The condition c∗E ≥ c∗LR is equivalent to the following:
1−γ
R
1 ( 1−τ ) γ
R γ
1−γ ≤1 (11)
R
π + (1 − π)( 1−τ ) γ

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Corollary 2: Necessary and sufficient condition on intrinsic
parameters for fragility

Corollary 2
Under (2) and a deposit freeze followed by court intervention, the banking
system is fragile if and only if (11) holds.

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Conditions on intrinsic parameters for fragility under
payment rescheduling

Corollary 3
Under (2) and a deposit freeze followed by court intervention, for any
γ ≤ 1, there exists τ̄ ≤ 1 such that τ ≥ τ̄ implies that the banking system
is fragile.

Corollary 4
Under (2) and a deposit freeze followed by court intervention, given all
other parameter values, there exists γ̄ ≥ 1 such that γ ≥ γ̄ implies the
banking system is fragile.

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The perils of institutional constraints

Observation 1
Institutional constraints that make it difficult to reschedule payments do
not mitigate the problem of fragility; instead, they make fragility more
likely to obtain.

Institutional constraints (IC): The court system in Argentina often

awarded depositors the right to withdraw the entire face value of their
deposits. Even after the peso was devalued, some depositors were
awarded the value of their deposits in dollars at the pre-devaluation
exchange rate (c∗E ).
IC’s in our model: Suppose that, once deposits are frozen, the
authorities can sort depositors by type, but are not able to decrease
the early payment to c∗ER . Suppose, instead, that the remaining
impatient depositors are each given bcER , with c∗E ≥ b
cER > c∗ER
∴bcLR < c∗LR (feasibility)
∴ The condition for fragility is strictly weaker than (11).
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Significance of various model features

1 Significance of SSC: Immediately upon withdrawal, depositors can

convert their funds into assets that are difficult for the authorities to
reclaim and/or tax.
2 Why is it important to implement the efficient continuation
allocation (c∗ER , c∗ER ) as soon as possible?
Policy responses and their implications hurt the later withdrawers but
cannot affect the initial ones
Connection to currency crises
3 Aggregate shortage: In case of a bank-specific run, interbank
liquidity reallocation may help avoid crisis.
A liquidity buffer - available to banks only in the event of a run - can
easily be incorporated in the model
However, maintaining such a buffer has a cost: it prevents the
economy from achieving the first-best allocation in the event that a run
does not occur.

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Outline

1 Introduction

2 The model

3 The first best allocation

4 Deposit freeze

5 Payment Reschedulings

6 Conclusion

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Concluding remarks
1 The behavior of individuals during a banking crisis depends crucially
on how they expect the authorities to respond to events.
2 If depositors know that the authorities would freeze all remaining
deposits in the event of a run, then the run can be prevented.
3 However, if a run were to take place ex-post, the response could turn
out to be quite inefficient.
4 By deriving ex-post efficient policy responses the authors show how
these interventions can generate an ex-ante incentive for depositors to
participate in the run, precipitating a self-fulfilling run.
5 3 cases- late intervention, risk averseness of depositors, court
intervention that follows the bank freeze.
6 Applications and extensions: The analysis can be applied elsewhere
directly. Money market and related funds, for example, closely
resemble the banks in our model. Asset markets also show similar
characteristics. Observers claim that certain episodes in these markets
are analogous to a bank run; e.g. the stock market crash in 1987.
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