Bank Runs, Portfolio Choice, and Liquidity Provision
After the financial crisis of 2007–09, many jurisdictions introduced new banking regulations to make banks more resilient and less likely to fail. These regulations included tighter limits for the quality and quantity of bank capital and introduced minimum standards for liquidity. But what was the impact of these changes?
To find out, we study a model of bank runs. Our goal is to provide a first step of the analysis and study a completely unregulated economy. In particular, we introduce safe assets to partially guard against investment risk and examine how the portfolio choices that banks make affect:
- their resiliency in (wholesale) funding markets,
- the welfare of investors who have made deposits with these institutions, and
- the liquidity that banks provide to investors using demand deposits.
Upon receiving some interim information about the future investment return, the bank optimally chooses its portfolio mix We find that allowing for a portfolio choice of banks:
- reduces the probability of a bank run,
- increases the welfare of investors, and
- allows banks to provide more liquidity.